single use reprint from Vol. 8, No. 1, Jan/Feb 2010
©2010 Xander Media Group, Inc. ABF Journal is an Xander Media Group (XMG) publication. The views and opinions expressed in this publication
throughout editorial and advertisements are not necessarily those of XMG management. All rights reserved. Reproduction, duplication or redistribution
in whole or in part is not permitted without express written permission of the publisher.
sPecial series: FielD eXaMS (ParT i)
Critical assessment —
The True Face of Dilution
By Gilles Benchaya anD GreGory anDerson
Field examiners may spend a considerable time scrubbing a borrower’s trade accounts receivable (a/r).
often the resulting ineligibles proposed are met with the following question: “isn’t this all covered by
dilution?” Knowing the answer to the question is critical to ensuring that the borrowing base formula
adequately protects an asset-based lender.
F
GilleS BenChaya
Partner,
Richter Consulting, Inc.
GReGoRy anDeRSon
Senior Associate,
Richter Consulting, Inc.
ield examiners often spend considerable time
diligently scrubbing a borrower’s trade account
receivables (A/R) by performing, among other
procedures, confirmations, testing of invoices, shipping, credit note, partial payments and review of
customer agreements and analysis of accounting
reserves. These procedures lead to the formulation of
a list of potential borrowing base (Bbase) ineligibles
for the lender. More often than not, the proposed ineligibles are met with some skepticism and the following
question “Aren’t these all covered by dilution?” The
question may come from a borrower concerned with
Bbase availability or an account manager concerned
over the impact on a relationship and/or a deal closing.
Regardless of the motivation, the answer is critical to
ensuring that the Bbase is formulated to adequately
protect an asset-based lender’s interest.
the Basics
Prior to answering the question, it would be useful to
review the mechanics of an A/R Bbase. A Bbase is
simply a calculation that determines the amount that
an asset-based lender is willing to lend to a specific
borrower. The Bbase utilizes a borrower’s financial
information to estimate the realizable value of its
collateral in a liquidation scenario. Asset-based lenders
rely on two metrics to estimate the A/R liquidation
value, namely ineligibles and dilution.
A/R ineligibles represent specific items that an
asset-based lender does not wish to lend against due
to their associated credit risk. The more common
ineligibles include A/R aged greater than 90 days past
invoice date, foreign receivables, contra accounts and
30 • abfJournal • jan/feb 2010
disputes. Table 1 reflects a typical A/R Bbase net of
ineligibles:
Table 1
A/R Bbase
A/R Aging
Ineligibles
> 90 days old
Foreign
Disputes
Total ineligibles
Eligible A/R
$ 200
(30)
(10)
(20)
(60)
$ 140
Table 3
The second
metric utilized by the asset-based
A/R Bbase
lender to estimate liquidation
value is dilution. Dilution
measures the risk associated with the collection of
A/R Aging
200
A/R. A dilution analysis attempts to estimate the ultiIneligibles
mate collection for every dollar of A/R on the books.
> 90 days old
(30)
The analysis
will consider various dilutive
elements
including
credit notes (for returns, errors,
Foreign
damages,
(10)
etc), write-offs (i.e., for bad debt), payment discounts,
Disputes
(20)
as well as customer rebates and allowances. Dilution
Total ineligibles
credit
(60) and
is impacted by a company’s trade policies,
Eligible A/R
140financollection
procedures, as well as its customers’
cial health
and is usually expressed as a percentage
Advance rate
83% of
sales (dilution rate) with the most common method of
Available A/R
116
calculation as follows:
Dilution Rate = Dilution/Gross Sales for
trailing 12-month period
Table 2
Annual Sales, Dilution, & Dilution Rate
Gross Sales ‐ A
Dilution
Returns
Billing errors
$ 200
4
1
Table 3
A/R Bbase
single use reprint from Vol. 8, No. 1, Jan/Feb 2010
A/R Aging
200
©2010 Xander Media Group, Inc. ABF Journal is an Xander Media Group (XMG) publication. The views and opinions expressed in this publication
throughout editorial and advertisements are not necessarily those of XMG management. All rights reserved. Reproduction, duplication or redistribution
Ineligibles
in whole or in part is not permitted without express written permission of the publisher.
> 90 days old
(30)
Foreign
(10)
Disputes
(20)
Total ineligibles
(60)
Eligible A/R
140
Advance rate
83%
Available A/R
Examples
of dilutive elements as well
as 116
a calcula- aren’t We Double Counting?
tion of the annual dilution rate is presented in Table 2:
Table 2
Annual Sales, Dilution, & Dilution Rate
Gross Sales ‐ A
Dilution
Returns
Billing errors
Damages
Discounts
Rebates
Write‐offs
Total Dilution ‐ B
Dilution Rate ‐ B/A
$ 200
4
1
2
1
3
1
12
6%
A frequently asked question is: “Why do I need all these
ineligibles if I am factoring in dilution?” At this point
we need to take a step back and consider the purpose
of advance rates and ineligibles. Ineligibles are meant
to exclude receivables whose collection is doubtful or
problematic. Once the “ineligible receivables” have been
removed, the advance rate then estimates how much of
the “eligible receivables” could be collected in a liquidation scenario. Put simply, ineligibles get rid of the bad
receivables while the advance rate estimates how much
of the good receivables could turn bad in the future.
While the above is a useful starting point, it leaves a
field examiner and account manager with the following
question: How does one identify the pool of eligible
receivables and ensure that the ineligibles established
have not already been addressed by dilution (i.e., the
advance rate)?
Breaking Down Dilution
Dilution is critical in evaluating A /R over an
extended time period and is an essential metric for
asset-based lenders. One of the common methods
for calculating the Bbase A/R advance rate takes into
account dilution as follows:
BBase a/R aDvance Rate = 100% - (2*Dilution
Rate) - 5%
Based on the above example, a company with a
dilution rate of 6% would have a Bbase A/R advance
rateTable 1
of 83%. In doubling the historical dilution and
adding a further 5%, the advance rate is meant to
A/R Bbase
provide a “cushion” to a lender to protect against the
higherA/R Aging
collection risk. In a liquidation scenario
$ 200collections Ineligibles
are more problematic when a company ceases
operations as certain customers demand proof for all
> 90 days old
(30)
shipments, exaggerate disputes, claim damages, etc.
Foreign
(10)
While
there are numerous methods
of estimating
(20) on
dilution Disputes
and setting advance rates, we have
focused
the more
common method outlined above.
Accordingly,
Total ineligibles
(60)
a typical
A/R Bbase for a company with
a 6%
dilution
Eligible A/R
$ 140
could be as follows:
A/R Bbase
A company generates $100 of sales per month,
which is collected 31 days after the invoice date. The
31 days is considered the “collection period.” The
company has returns of 5% of gross sales each month
(dilution rate), which are recorded as credit notes 61
days after the invoice date (credit lag). An A/R aging
and effective dilution based on the above assumptions
is as follows:
200
(30)
(10)
(20)
(60)
140
83%
116
Table 2
Annual Sales, Dilution, & Dilution Rate
Gross Sales ‐ A
Dilution
Returns
Example #1:
Example 1
A/R Aging and Unrecorded Dilution
Table 3
A/R Aging
Ineligibles
> 90 days old
Foreign
Disputes
Total ineligibles
Eligible A/R
Advance rate
Available A/R
The key to answering this question understands how
the dilution calculation works. The dilution rate is
calculated based on a historical average that is then
applied to the A/R at a point in time to estimate collectability. Accordingly, if 5% of yearly gross sales were
dilutive, A/R is assumed to also be 5% dilutive.
This logic only holds if the composition of sales
and A/R are equivalent. However the issuance of credit
notes and the write-off of uncollectable accounts often
lag the collection of “good” receivables. The end result
is that the dilution level in A/R is often significantly
higher than the dilution rate determined on sales. The
following example illustrates this point.
A/R Unrecorded dilution
Expected Dilution %
Days Past Sale (Invoice date)
0‐30
31‐60
61‐90
>90
100
5
‐ ‐ 5 5
‐ ‐ 5.0%
100.0%
0.0%
0.0%
Included in dilution rate
Not included in dilution rate
Example 2
Sales
made in the current month are fully reflected
A/R Aging and Unrecorded Dilution
in the 0-30 day column of the A/R aging and would Days Past Sale (Invoice date)
include $5 of future dilution (5% dilution
factor).
Total
0‐30
31‐60
61‐90
A/R Unrecorded dilution
Expected Dilution %
$ 200
4
Total
105
10
9.5%
110
15
13.6%
100
5 5.0%
Included in dilution rate
Example 3
5
5
100.0%
5
5
100.0%
Not included in dilution rate
>90
‐ ‐ 0.0%
jan/feb
2010 • abfJournal • 31
single use reprint from Vol. 8, No. 1, Jan/Feb 2010
©2010 Xander Media Group, Inc. ABF Journal is an Xander Media Group (XMG) publication. The views and opinions expressed in this publication
throughout editorial and advertisements are not necessarily those of XMG management. All rights reserved. Reproduction, duplication or redistribution
in whole or in part is not permitted without express written permission of the publisher.
Sales made 31 to 60 days ago (refer to the 31-60
day column above) would have been collected as
customers pay in 31 days however as the related credit
notes are only issued after 61 days, the 31-60 day
aging column would still contain a $5 balance that is
uncollectible (i.e., 100% dilutive). This additional diluExample 1
tion is the result of the credit lag.
A/R Aging and Unrecorded Dilution
Accordingly, while the dilution rate is 5% of gross
Days Past Sale (Invoice date)
sales, the effective dilution rate on A/R is 9.5% (nearly
Total
0‐30
31‐60
61‐90
>90
double the dilution rate!).
A/R Unrecorded dilution
Expected Dilution %
105
100
5
‐ ‐ 5
5
‐
‐ 10
Example #2
9.5%
5.0%
100.0%
0.0%
0.0%
In the above scenario, the gap in dilution due to
credit lag is further amplified if the credit notes were
only processed in 91
days versus 61 days, as noted in
Included in dilution Not included in the following example:dilution rate
rate
Example 2
A/R Aging and Unrecorded Dilution
A/R Unrecorded dilution
Expected Dilution %
Total
110
15
13.6%
Days Past Sale (Invoice date)
0‐30
31‐60
61‐90
>90
100
5
5 ‐ 5 5
5 ‐ 5.0%
100.0%
100.0%
0.0%
Included in dilution rate
Not included in dilution rate
Example 3
In the scenario on page 31, the dilution rate on
A/R Aging and Unrecorded Dilution
May 28
sales remains at 5%, however the effective dilution
rate on A/R Days Past Sale (Invoice date)
increases to 13.6% (almost triple the sales
Total dilution rate).
0‐30
31‐60
61‐90
>90
While 100
most situations
the collection
A/R 150
5involve
5 of 40A/R
processing
of 5credit 5 there
Unrecorded dilution
55
prior
to the5
notes,
are 40
rare
Expected Dilution %
36.7% occasions
5.0%
100.0%
when credit
notes are100.0%
recorded in100.0%
advance
of collections (i.e., extended payment terms). In these
situations the sales dilution rate would overstate the
Included in dilution Not included in effective level of dilution in A/R.
rate
dilution rate
the Dilution Cushion
Example 4
A/R Aging and Unrecorded Dilution While the examples shown demonstrate that the annual
dilution rate is not always an effective measure of diluMay 28
tion in A/R,Days Past Sale (Invoice date)
lenders typically take comfort in the fact
Total that the 0‐30
31‐60
>90
Bbase advance
rate often 61‐90
doubles the dilution
and 100
includes a further 5 5% “cushion.”
A/R 150 rate 5 40
Ineligibles
(40) ‐ may
‐ use
‐ “cushion”
(40)to
While this
be valid
of the
Eligible A/R
110 provide
100
5 less
a buffer for credit 5 lag it
leaves
room‐ for
Unrecorded dilution
15
5 contingencies
5that 5 ‐ unforeseen
could occur
in a liquiExpected Dilution %
13.6% dation scenario.
5.0%
100.0% could 0.0%
In 100.0%
addition a company
inflate
Bbase collateral simply by reducing the timeliness of
credit note processing accordingly, the cushion may
Included in dilution not really exist.
rate
Example 5
A/R Aging and Unrecorded Dilution
May 28
A/R Unrecorded dilution
Expected Dilution %
32 • abfJournal • jan/feb 2010
Total
$ 100
55
55.0%
Not included in dilution rate
Days Past Sale (Invoice date)
0‐30
31‐60
61‐90
>90
$ 100
$ ‐
$ ‐ $ ‐
5 5
5 40
5.0%
N/A
N/A
N/A
Included in dilution rate
Not included in dilution rate
a Simple Rule of thumb for Credit lag
A simple but often effective rule of thumb for adjusting
dilution to account for credit lag is as follows:
Average Credit Lag in Days / Average Collection Time in
Days * Dilution Rate = effective Dilution on a/R
Utilizing this rule of thumb, the effective dilution
rate in examples 1 and 2 would be as follows:
example #1: 61 / 31 * 5% = 9.8%
example #2: 91 / 31 * 5% = 14.7%
While this simple rule of thumb results in a better
approximation of the actual dilution, it is not a mathematical proof and may not apply in all instances.
The outline to date leads to our first rule of dilution:
If the credit lag is greater than the collection period,
the effective A/R dilution will be greater than dilution
based on gross sales.
Now that the first rule of dilution has been established, the next article in this series will focus on field
exam techniques used to identify and quantify effective
dilution. abfJ
GilleS BenChaya is a partner at Richter Consulting,
Inc., a member of the full-service business advisory
firm Richter Group, which specializes in financial advisory, turnaround and diligence in the retail, consumer
goods and distribution sectors for the past 20 years.
Benchaya has led a number of multidisciplinary teams
in North America and Europe providing fully integrated
transaction support and advisory services to clients.
He is a chartered accountant (CA) and graduate of
HEC (University of Montreal) Business School. He can
be reached at gbenchaya@richterconsulting.com.
GReGoRy anDeRSon is a senior associate at
Richter Consulting. He has extensive experience
as an advisor to financial institutions with specific
expertise in asset-based lending. He has consulted
on field examination and lender monitoring processes
as well as loan workouts. Anderson is a CA and
Certified Fraud Examiner (CFE). He can be reached
at ganderson@richterconsulting.com.