What it means
The idea is deliberately blunt: before arguing about how likely a bad outcome is, work out how large it would be. A company owed $500,000 by one customer has $500,000 of credit exposure to that customer, regardless of how reliable they have been for the past decade.
Sizing the exposure first stops optimism from doing the risk assessment. Exposure matters because concentration is what usually kills businesses rather than volatility itself.
Losing 3% of revenue is survivable almost anywhere; losing a customer who represents 35% of revenue rarely is. Boards therefore ask about exposure by counterparty, by market, by currency and by supplier, and set limits on each.
In practice exposure is measured and then reduced. Credit exposure can be capped with limits, shortened payment terms, deposits or credit insurance; currency exposure can be reduced by invoicing in your own currency or by using forward contracts; interest rate exposure can be fixed rather than floating.
Each of these costs something, so the question is always whether the protection is worth the price. The nuance is the difference between gross and net exposure.
A business importing $2,000,000 of goods in euros while also exporting $1,500,000 in euros only has a net exposure of $500,000, because the flows partly offset one another. Managing the gross figure when the net one is small wastes money on hedges you do not need.
In practice
Real-world examples.
Example
An engineering firm invoices a Japanese client in yen for a contract worth about $900,000. Between signing and payment the yen weakens by 7%, and the firm receives roughly $63,000 less than expected because it left the currency exposure open.
Example
A property developer takes a $4,000,000 floating rate loan. A two percentage point rise in rates would add $80,000 a year to interest costs, so the board fixes half the balance to cap the exposure at a level it can absorb.
Example
A food manufacturer buys 70% of its packaging from a single plant. When that plant floods, production stops for eleven days, and the exposure turns out to be operational as well as financial.
Formula
Calculation
Expected Loss = Exposure x Probability of Loss x Loss Given Default
where loss given default is the share of the exposure you would fail to recover.
A supplier is owed $500,000 by a customer. Based on the customer's credit rating the supplier estimates a 4% chance of failure in the next year, and expects to recover 40% of the debt through an administration process, so the loss given default is 60%.
Expected loss = $500,000 x 4% x 60%
= $500,000 x 0.04 = $20,000
= $20,000 x 0.60 = $12,000
The expected loss is $12,000, while the exposure remains $500,000. That gap is the point: if credit insurance costs $9,000 a year, it is cheap relative to a worst case that would wipe out a year of profit, even though the average expected cost is only slightly higher than the premium.Case study
Seen in the real world.
Brightfen Components is an invented electronics supplier used purely to illustrate the concept of exposure. It had revenue of $4,000,000, of which $1,400,000, or 35%, came from one appliance manufacturer that had paid on time for six years.
The illustrative finance director calculated the exposure rather than the probability. If that customer failed, Brightfen would lose an average receivable balance of about $290,000 plus the contribution from more than a third of its sales, and the factory was sized for that volume. The board had never seen the two numbers side by side.
Brightfen responded by insuring the receivable, negotiating a shorter payment cycle, and setting a target of no customer above 20% of revenue within three years. When the customer was acquired two years later and moved its supply chain elsewhere, the fictional company lost margin but stayed solvent.
Watch out
Common mistakes.
- Confusing exposure with expected loss. Exposure is the full amount at risk, while expected loss weights it by probability, and only one of those numbers can bankrupt you.
- Measuring exposure only in dollars owed. Losing a customer also removes the contribution that covers fixed costs, so the real hit is usually larger than the invoice.
- Hedging gross positions without netting them off first. Offsetting flows in the same currency or the same rate reduce the exposure you actually need to cover.
Questions
People also ask.
How often should exposures be reviewed?
At least quarterly for credit and currency, and immediately when a counterparty's circumstances change or a large new contract is signed.
Is all exposure bad?
No, taking exposure is how businesses earn returns; the aim is to be paid properly for the exposures you choose and to avoid the ones you are not paid for.
What is a sensible customer concentration limit?
Many mid-sized firms aim to keep any single customer below 20% to 25% of revenue, though the right level depends on contract length and how easily the customer could be replaced.
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