What is dilution in asset-based lending?

Why dilution matters to a lender

An asset-based lender advances a share of each eligible receivable on the assumption that the receivable will be paid, in cash, close to its face value. Asset-based lenders typically advance 80% to 90% of eligible receivables. The gap between the advance and the face value is the lender's cushion, and it has to cover everything that could make a receivable collect less than it says: a return, a pricing credit, an early-payment discount, a customer who short-pays and a customer who never pays at all.

Those reductions are dilution. If they are small and steady, the cushion covers them comfortably. If they are large, or growing, the lender's collateral is worth less than the borrowing base says, and the cushion is being spent before any real trouble begins. That is why dilution is one of the first things a field examiner measures, and one of the findings most likely to change the terms of a line.

Dilution is not a loss the lender takes. It is a loss the borrowing base has already counted as collateral.

What counts as dilution

Anything that reduces the amount owed on an invoice other than the customer's payment counts. The common categories:

• Returns. Goods sent back, with the invoice credited in full or in part.
• Credit memos and pricing adjustments. Billing errors, price protection, volume adjustments after the fact.
• Discounts. Early-payment terms that let customers pay less than face value if they pay quickly.
• Allowances and rebates. Promotional allowances, markdown allowances and volume rebates settled against receivables.
• Customer deductions and chargebacks. Amounts a customer simply withholds from a payment for shortages, late delivery, compliance fines or disputed charges.
• Bad-debt write-offs. Balances written off as uncollectible.

What does not count is the passage of time. Slow payment is handled by the aging rules, not by dilution: receivables more than 90 days past invoice are typically ineligible, and cross-aging can exclude a slow customer's whole balance. Offsets against amounts the business owes a customer are handled as contras. Dilution is about value that disappears, not value that arrives late.

How lenders calculate it

The standard calculation is simple: total dilutive items over a period, divided by gross invoiced sales over the same period. The examiner builds it from the sales journal, the credit memo register, the ledger accounts where discounts and allowances are booked, and the write-off history. Most lenders look at a trailing twelve months, which smooths seasonal swings, and also at the most recent months, which shows whether dilution is getting worse.

A worked example, for a consumer products distributor over twelve months:

Two refinements are common. First, timing: a credit against March's sales may not be issued until May, so examiners either match credits to the month of the original sale or use a period long enough that timing washes out. Second, some lenders cross-check the result with a collections test, following each month's invoiced sales through to cash and seeing what share was eventually collected. If the two methods disagree, it usually means credits are being booked somewhere the examiner has not yet found, such as deductions netted against payments without a credit memo.

What happens when dilution runs high

Every advance rate carries an assumption about dilution. The loan agreement or the lender's credit policy sets the level of dilution the advance rate already allows for. When measured dilution runs above that level, the lender has two tools, and the agreement usually lets it use either in its reasonable credit judgment.

• A dilution reserve. The lender keeps the advance rate but deducts a reserve from availability, sized to the excess dilution applied to eligible receivables. This is an availability reserve like any other, and it can be lifted when dilution comes back down.
• A lower advance rate. The lender reduces the advance rate by the amount dilution exceeds the allowed level, point for point. The effect is similar, but a changed advance rate is harder to reverse than a reserve.

Continuing the example: the distributor's agreement allows for dilution of 5 of every 100 invoiced, but the exam measured 8. Eligible receivables are 1,500 and the advance rate is 85%.

Either way, availability drops by 45. If the line was drawn close to the old availability, that 45 has to come from somewhere, and a business already near its limit can find itself in an overadvance. Dilution findings also affect renewals and the lender's willingness to accommodate seasonal peaks.

High dilution is expensive twice: once in the margin the credits cost, and again in the borrowing base they shrink.

Where dilution runs high, and why

Dilution is largely a function of how an industry sells. Lenders know the patterns and underwrite them:

Industry pages go further: see lines of credit for wholesale distributors and apparel brands and retailers.

How to keep dilution down, and measured fairly

Some dilution is simply the cost of selling to certain customers. Much of what examiners find, though, comes from how it is recorded:

• Record credits promptly, with a reason code. A backlog of unissued credits shows up all at once and looks like a trend.
• Fix billing errors at the source. Pricing credits caused by bad price files are avoidable dilution.
• Track deductions separately and resolve them. Deductions left unapplied make receivables look collectible when they are not, and examiners will find them.
• Weigh early-payment discounts. A discount taken is dilution. It may be worth it for cash flow, but it is not free in the borrowing base.
• Accrue rebates visibly. Lenders often reserve for rebates owed to customers; a clean accrual schedule keeps that reserve accurate rather than estimated high.
• Never bill ahead of shipment. Pre-billed invoices later credited are dilution, and a representation problem.

When a business is applying for a line, showing its own dilution calculation, with the credit memo register behind it, is a strong move. A lender that sees dilution measured and explained before the field exam has less reason to reserve conservatively. For the fuller picture of how dilution fits the base, see dilution and your borrowing base, and for the alternative that works on some of the same collateral, factoring vs asset-based lending.