What are dilutions?
I don't know where this term originated in the context of invoice finance, but it is quite appropriate. When you think about "dilution", you immediately think of liquids. If I have a pint of beer and I add water to it (a terrible thing to do), I will be diluting it and making it weaker. If you carry that analogy into invoicing financing, the starting assumption is that all the invoices assigned to a finance provider (factoring company, bank, etc.) will be 100% paid by the client's customers - the debtor. As the value of the invoices is the collateral or asset, we're using to secure the lending facility, if it is 100% collectable, happy days. However, if it isn't 100% collectable, the finance provider's collateral is weaker and has been diluted.
What is it that can reduce the value of invoices?
Well, there may have been a mistake or error on the part of the client and the invoice needs to be adjusted or reissued. In this case, the client issues a credit note for all or part of the invoice value. Another thing that is quite common in business, is for a supplier (the finance provider's client) to offer its customers an early settlement discount. Generally, this is a percentage, say 2%, that the customer (debtor) can underpay the invoice, in exchange for paying the invoice early. The other thing that can occur is that, for whatever reason, the debtor simply underpays the invoice by a trivial amount. There is no point chasing the debtor for the minor amount, so we effectively raise a credit adjustment to clear off the invoice balance remaining. Finally, the invoice may not be collectable, and the finance company needs to remove it from the sales ledger. This is generally by way of a reassignment transaction (assign or transfer the invoice back to the client).
Collectively, these events reduce the value of the invoices that the finance provider is lending money against. Rather than collecting 100%, our ability to collect is diluted by anything that credits the invoice, that isn't money. When people talk of dilutions in respect to invoice finance, what they mean is the sum of all discounts, credit notes, adjustments, and reassignments, because they all weaken the underlying collateral - the value of the outstanding invoices.
This is often represented by a percentage. If we have €200,000 of invoices in a month, and €20,000 of "dilutions", our dilution percentage is 10%. This is one of the reasons why a finance company doesn't advance 100% of the invoice value to a client; in reality, they may not be able to collect 100% of the invoice value. Just as an aside, another related term is collectability. This is the opposite to dilution, as it is the amount of money we are really managing to collect. In the previous example, the dilution was 10% so the collectability is 90%.
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Article written by: Kevin Day