Meaning
Reductions applied to the value of accounts receivable to account for non-cash losses like returns and discounts provide a conservative estimate of collectible cash. A dilution haircut protects lenders by ensuring they do not over-advance funds against assets that will never turn into money. This adjustment is based on historical data regarding how much of the gross invoice value is typically lost to commercial adjustments.
Valuation Adjustment
Asset based lenders use this discount to determine the borrowing base for a credit facility. The dilution haircut is subtracted from the eligible receivables before applying the advance rate.
Asset Protection
Calculating the appropriate percentage requires a look at the previous twelve months of credit activity. If the dilution haircut is set at five percent, the lender assumes that only ninety five cents of every dollar invoiced will actually be paid in cash. This calculation is updated during periodic audits to reflect changes in customer behavior or product failure rates.
Loss Buffer
Unforeseen spikes in returns can threaten the solvency of a leveraged company. Maintaining an accurate dilution haircut prevents a situation where the outstanding loan exceeds the value of the underlying collateral. It acts as a buffer against the erosion of the asset pool during economic downturns.
