Dilution in Invoice Finance: a Worked Example

A receivables financier lends against what customers owe. An invoice for US$100,000 is worth that only if the customer owes US$100,000, and many of the things that reduce the amount owing have nothing to do with the customer's ability to pay. Goods come back. A delivery arrives short. A retailer deducts an allowance when it settles. The price on the invoice was wrong. Each produces a credit rather than a payment, so the collateral shrinks with no cash reaching the account.

Supervisors use the word the same way. The Basel capital standards for purchased receivables define dilution as the possibility that the receivable is reduced through cash or non-cash credits to the obligor, and give returned goods, quality disputes, debts the seller owes the customer, and payment or promotional discounts as examples. Definitions differ at the edge: the US national-bank supervisor's handbook counts bad debts among the sources. Many financiers, and this page, treat bad debts as a separate credit risk.

The formula is short and the choices inside it are not. Credit notes that only correct and reissue an invoice are usually taken out, because the customer still owes the money. Bad-debt write-offs are left out so they are not counted twice, and so are deductions already handled elsewhere in the calculation. The period matters as well. A twelve-month figure smooths the year and a three-month figure catches a change sooner, so a lender usually reads both.

Timing adds a further difficulty. A credit note issued in April often relates to a March invoice, or to something sold last year. Where notes lag the sale, the ledger contains invoices already destined for credit, and a rate measured on sales understates the share of today's ledger affected. A field exam therefore tests a sample of credit notes against the invoices they reduce.

A supplier of private-label snack foods to supermarkets, constructed for this page like every figure in it, invoices US$48.0m a year, has a ledger of US$6.0m at its June year-end and is financed at 85%. Twelve months of credit notes, in US$m:

At 5.6%, the 15% the financier does not advance looks ample. But more than half of that figure is one item. The volume rebate accrues through the year and is settled in a single credit in July, so the June ledger carries a deduction the average conceals:

The financier deducts the accrued rebate from the eligible ledger as a specific item and removes it from the rate, so it is not counted twice. What remains is US$1.2m on sales of US$48.0m, or 2.5%, and that is the figure the advance rate has to allow for. Two suppliers can share a headline of 5.6% and need different terms, depending on whether the credits arrive evenly or in a lump. Every percentage here is the example's and not a market norm.

A bad debt is money truly owed by a customer that cannot pay. Dilution is a debt that was not fully owed, or stopped being owed. The protections do not overlap. A credit check on the customer says nothing about whether the goods were right. Trade credit insurance generally responds to insolvency or protracted default and leaves a disputed debt outside cover until the dispute is resolved. Recourse lets a financier come back to its client for an unpaid invoice, which helps little once the client has failed.

Dilution also tends to move against the lender at the worst moment. A supplier in trouble ships late, quality slips and customers begin to claim. Once it stops trading, customers with warranty claims or unfilled orders have every reason to deduct them. A rising rate can therefore be a warning about the business itself, a point the US supervisor's handbook makes directly. Contra, where a customer is also a supplier, is a related exposure that can be seen in advance.

DEFINED IN ONE PARAGRAPH → · THE ADVANCE RATE IT FEEDS → · INVOICE FINANCE →

Before a facility is signed, the financier asks for the credit-note history and reads it beside the aged debtors report. The answer goes into the advance rate and, where dilution runs above a level agreed in the document, into a reserve that takes the excess off availability. It also touches eligible receivables: rebate accruals, disputed amounts and unapplied credits may be deducted from the pool directly, and the lender has to see that the same dollar is not deducted twice.

After signing, the rate is a number to watch. A jump in credit notes that coincides with a new customer or product line says something about what the business is now selling. For the borrower, the practical point is that a large rebate agreed with a retailer reduces funding as well as margin, and it does so on the date it is credited rather than the day it was promised.