One of the most commonly used terms in factoring and receivable financing is "dilution". Dilution is the difference between the face amount of an invoice or group of invoices and what the customer or account debtor actually pays.
The following is a simple example:
Acme dress manufacturer invoices ABC retail company $10,000 for goods that ABC ordered. ABC receives the shipment and upon inspection finds that some of the goods are damaged. Instead of returning the damaged goods to Acme to be replaced, Acme authorizes ABC to deduct the value of the damaged goods from its payment to Acme. The deduction from the damaged goods totals $1,000 so ABC pays Acme $9,000. The $1,000 deduction that ABC takes is dilution.
On a company's financial statements dilution is represented as the difference between gross and net sales on the income statement.
The reason dilution is so important to factors and asset based lenders is because dilution will directly affect their ability to be repaid on the advances they make against accounts receivable. It is easy to understand that if a factor makes an advance of 80% against the face value of an invoice and dilution is 30% the factor is making a loan or advance that exceeds the value of the collateral. As part of the preperation for engaging with an accounts receivable lender you need to have an understanding of what your company's dilution is. You will insipire confidence If you are able to give the factor an accurate estimate of your companies dilution. They will feel like you have a strong understanding of your business and its potential relationship with a finance company.
Calculating your dilution is relatively simple. We will be discussiong other variation of dilution in the next article in this series but I will be using the most commonly used calculation now. You only need to know two things before you calculate your dilution:
- Gross sales for the last 12 months
- Collections for the last 12 months
To make it simple lets say for the last 12 months you billed $1,000,000, so $1,000,000 is your gross sales number. During the same 12 months lets assume you collected $900,000. As we discussed above the difference between those two numbers is $100,000. $100,000 divided by $1,000,000 is 10%, so your company's dilution for the last 12 months is 10%.
In our next article we will discuss variations of the dilution calculation and how factors use dilution to establish and modify advances rates.
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