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What Is Dilution?

What is Dilution?

Dilution is any portion, regardless of why, of your receivables that you did not collect. This is important as the amount available from your line of credit with the bank is based on your outstanding accounts receivable balance. The bank wants to know the extent to which your receivables are likely to be turned into cash receipts. The greater the amount of dilution, the greater the risk to the bank and the less will be your available borrowing base.

The following are common causes of dilution and suggestions for remedying them.

Discounts

Discounts offered to customers for faster repayment can increase your dilution rate. But if these discounts account for a significant amount of dilution, you may consider other methods of encouraging faster repayment.

Collection costs

The greater the fees directly paid to collect on your receivables, the less of your receivables balance you will realize. This is worth examining to see if it has a material impact on your dilution rate. You may even consider less costly collection services.

Bad debt

Receivables not collected due to the default or other negligence of the customer. Reduce this through the establishment of tighter credit policies, such as more thorough credit checks prior to extending trade credit to customers.

Offsets

Sometimes a customer may also be a vendor. In the course of paying an invoice it may seem attractive to you or them to net out the amount they owe you from the invoice’s total. Although, you may want to end this practice depending on the amount of the dilution and its subsequent impact on your borrowing base availability.

dilution

See Also:
Financial Ratios
Accounts Receivable Turnover
How to collect accounts receivable
What is Factoring Receivables?
Working Capital

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Allowance for Uncollectible Accounts Explained

See also:
Does Your Management Team Understand the Financials?
General Ledger Reconciliation and Analysis
Allowance for Uncollectible Accounts

Allowance for Uncollectible Accounts Explained

When companies sell products to customers on credit, the customer receives the product and agrees to pay later. The customer’s obligation to pay later is recorded in accounts receivable on the balance sheet of the selling company. However, sometimes customers simply don’t pay their bills. When customers don’t pay their bills, the selling company has to write-off the amount as bad debt or uncollectible accounts.

In anticipation of the fact that some customer’s will not pay their bills, a company will create an account on the balance sheet called allowance for uncollectible accounts. You can also call this allowance for doubtful accounts. This account is a contra asset account the value of which is subtracted from the value of the accounts receivable account on the balance sheet. Companies must estimate the amount of uncollectible accounts based on historic data. Then companies must apply a certain percentage of accounts receivable to the uncollectible accounts account using the percentage rate determined by analyzing the historical data.

Direct Charge-Off Method: Meaning

One way to record the affects of uncollectible accounts is the direct charge-off method. This method is simple. But it violates the matching principle and does not conform to GAAP standards and procedures. Thus, it cannot be used to record the write-offs of uncollectible accounts in financial statements prepared for the public in accordance with FASB and GAAP regulations.

In the direct charge-off method, once the company determines that a certain amount due to the company will not be collected at all, the company writes it off in that fiscal period. In other words, the company writes off the bad debt expense once it realizes the bill will not be paid. The amount of bad debt is then subtracted from accounts receivable and added to bad debt expense or uncollectible accounts expense. This is the simplest way to record uncollectible accounts or bad debt.

Allowance Method

Another way to record bad debt expense or uncollectible accounts in the financial statements is by using the allowance method. This method adheres to the matching principle and the procedural standards of GAAP.

In the allowance method, a company estimates the amount of uncollectible accounts it will incur as a percentage of credit sales. Then they apply that percentage to credit sales as they earn the revenues. The allowance for doubtful accounts matches with the revenues. Even though this method uses estimation – as opposed to the direct method which writes off bad debt when the actual amount is known – the estimates may not always be entirely accurate. However, this method adheres to the matching principle. Therefore, it is the method approved by GAAP.

For more ways to add value to your company, download your free A/R Checklist. See how simple changes in your A/R process can free up a significant amount of cash.

allowance for uncollectible accounts explained

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allowance for uncollectible accounts explained

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Who Is Swimming Naked In Your Back Yard?

Warren Buffet has a saying that goes as follows…

“You never know who is swimming naked until the tide goes out”.

This past week there have been two major businesses who have been exposed as having been “swimming naked”. The major blow up was the investment manager Bernard Madoff, founder of Bernard L. Madoff Investments Securities LLC, to the tune of $50 billion. The other scandal was the lawyer Marc Dreier in New York for $280 million.

Both of these individuals were assumed to be the pillars of their profession and financially secure. In fact, both were big frauds waiting to be exposed. It was only after the financial stress of the past year caught up to them that the world discovered the truth. More to the point the only reason you heard about them is because they were large enough to make it in the Wall Street Journal.

Who Is Swimming Naked In Your Back Yard?

The real question going through your mind should not be about what they did or how they did it. But, instead you should be asking yourself is either:

Who in your community is doing the same thing or something similar?

Or who is swimming naked in your business community?

Often, what we see of people or businesses is only surface deep. I have know several individuals and companies over the years who appear successful on the surface but in reality they don’t have the financial strength to weather a shock to their systems. As this recession takes hold across the country we are going to see who has been fiscally conservative and who has been living on the edge.

As a business owner or CFO you need to be concerned about which receivable is going to be uncollectible. You can rest assured that somewhere in your accounts receivable ledger there is a bad debt that has not been exposed. Now is the time to tighten up your underwriting requirements and collect your old receivables.

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who is swimming naked
who is swimming naked

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