To measure how much a small business depends on its largest customers, work out each customer's share of revenue over the last 12 months, add up the share of the top three and top five, and track a concentration index such as the HHI. Add each customer's outstanding and overdue balances, because dependence weighs more when a large customer also pays late.
This article explains why customer concentration is a risk, how to do the calculations step by step, how to read the HHI and what to do when dependence is high.
Why is customer concentration a risk?
A concentrated customer base is not a problem while everything goes well. It becomes one when the largest customer cuts orders, switches supplier, stretches payment terms or runs into difficulties of its own.
- Cash. A late payment from a customer worth 40% of revenue can be enough to squeeze the month's payments.
- Margin. A customer with a large share of revenue has more leverage to negotiate prices and terms.
- Planning. The forecast of incoming cash comes to depend on the decisions of a few companies.
- Company value. In a sale or a financing request, a concentrated customer base is usually seen as a risk.
How do you calculate each customer's share?
- Choose the period. The last 12 months avoid the effect of an unusual month or season.
- Add up revenue by customer from the sales invoices, excluding VAT and net of credit notes.
- Work out each customer's share by dividing their revenue by the total for the period.
- Rank customers from largest to smallest and add up the share of the largest, the top three and the top five.
- Repeat every month, because the trend matters more than a single snapshot.
These figures already answer two questions management often asks. How much revenue depends on the largest customer, and how many customers make up half of revenue.
What is the HHI and how do you read it?
The Herfindahl-Hirschman Index, or HHI, measures the concentration of a portfolio in a single figure. It is calculated by adding up the square of each customer's share. With shares expressed as fractions, the result runs from close to 0, for a widely spread customer base, to 1, when there is a single customer. On the points scale, it is multiplied by 10,000.
Imagine a company where the largest customer accounts for 40% of revenue, the second for 20%, the third for 10%, and the remaining 30% is spread across 30 customers at 1% each. The HHI is 0.16 plus 0.04 plus 0.01 plus 30 times 0.0001, or about 0.21. A company with ten customers at 10% each would score 0.10, half the concentration.
The advantage of the HHI over the share of the largest customers is that it reflects the whole portfolio. If the largest customer grows, the index rises faster than the percentage, because the share is squared.
Why add outstanding and overdue balances?
Revenue shows how much each customer weighs. Outstanding balances show how much money is currently in their hands. Overdue balances show what should already have come in.
A customer with 15% of revenue and half of the company's overdue balance deserves more attention than a customer with 30% who pays on time. The useful view therefore combines three columns, share of revenue, outstanding balance and overdue balance, customer by customer.
What should you do when dependence is high?
- Track the indicator every month and discuss it at the management meeting, alongside cash.
- Review the terms of the largest customers, especially payment terms and credit limits.
- Set a commercial diversification goal, for example a number of new customers above a given revenue level.
- Protect cash, with a forecast of incoming cash that shows the impact of a late payment from the largest customer.
- Avoid decisions that increase dependence without compensation, such as investments made for a single customer.
How does EngiFinance help track dependence?
EngiFinance is currently available only in Portugal, in Portuguese. EngiFinance is an online cash management application for small and mid-sized businesses. From the sales invoices issued in the invoicing software the company already uses, it shows revenue by customer and each customer's share of the total, and the concentration of the customer base through the HHI, in low, moderate and high bands. Alongside, it shows outstanding and overdue balances by customer.
Portuguese invoices are read through the AT QR code, and documents without a QR code are read by artificial intelligence. Reconciliation with bank statements, imported by file and without access to the accounts, shows what has already been received, and the 12-month forecast shows incoming cash from invoices still to be collected, with overdue amounts kept separate.
In a 20 minute meeting we show a complete month in EngiFinance, in an organisation with demonstration data.
Frequently asked questions
At what share is a customer too large?
There is no single figure, because it depends on the sector and the margin. A good starting point is to track the share of the largest customer and the top three every month and discuss with management what happens to cash if the largest one pays late.
What is the HHI?
It is the sum of the squares of each customer's share of revenue. It runs from close to 0, for a widely spread customer base, to 1, when there is a single customer, or to 10,000 on the points scale.
Which period should be used to measure concentration?
The last 12 months, updated every month. This avoids the effect of an unusual month or season and shows the trend.
Why look at overdue balances too?
Because a large customer who pays late weighs twice, on revenue and on cash. Overdue balances by customer show where the money that should already have come in is sitting.
Does EngiFinance calculate customer concentration?
Yes. EngiFinance, available only in Portugal and in Portuguese, uses the sales invoices to show revenue and each customer's share, the concentration of the customer base through the HHI in low, moderate and high bands, and outstanding and overdue balances by customer.