Credit notes, contras and dilution

When a client sells on credit and invoices £100, the financier funds a percentage of that £100 on the understanding that the debtor will pay it. Most of the time, it does. But some of that £100 never arrives as cash. It disappears into a credit note for damaged goods, a contra against something the client bought from the debtor, an early settlement discount, or a deduction the debtor simply takes.

Each of these reduces what the ledger is really worth. Together they are called dilution, and every credit controller on a funded ledger should understand them.

Credit notes

A credit note cancels all or part of an invoice. Clients raise them for returns, damaged goods, pricing errors, short deliveries and goodwill. A steady flow of credit notes is normal in most trades.

What matters to the financier is when they are raised and what they are raised against. A credit note raised against an invoice funded six weeks ago reduces a debt the financier has already lent against. Credit notes clustered just after month end, raised against older invoices, suggest the ledger was overstated when the funding was drawn.

The opposite is also a warning sign. A ledger with almost no credit notes, in a trade where returns are normal, may mean credit notes are being held back to keep invoices funded. That is the subject of the Withholding Credit Notes course in our fraud library.

Contras

A contra arises when the debtor is also a supplier to the client. Instead of paying in full, the debtor sets what the client owes it against what it owes the client, and pays the difference.

For the financier, the problem is that the funded invoice is only worth the net amount. If a debtor owes the client £20,000 and the client owes the debtor £8,000, the debt is worth £12,000 in cash, however the ledger shows it. Contras are easy to miss because they rarely appear on the client’s sales ledger at all: the evidence sits on the purchase ledger, or in a remittance advice that pays less than expected.

Credit controllers usually spot contras first, through short payments and remittances that “net off” something. Asking the client for its purchase ledger, and comparing names against the sales ledger, finds the rest.

Discounts and deductions

Settlement discounts for early payment, volume rebates and retrospective discounts all reduce cash received. In some trades, large customers take deductions for promotions, late deliveries or compliance fines, often without agreement and sometimes months after the invoice. These are especially common when supplying large retailers.

Measuring dilution

Dilution is usually measured over a period, often three or twelve months:

Dilution = credit notes, contras, discounts and other non-cash reductions ÷ invoices raised

For example, a client invoices £1,200,000 over a quarter. In the same period it raises £54,000 of credit notes, has £18,000 of contras and allows £6,000 of discounts. That is £78,000 of non-cash reductions, so dilution is £78,000 ÷ £1,200,000, or 6.5%.

How dilution shows up on the aged debt report

Dilution often hides in the older columns. An invoice that has been short-paid sits on the ledger with a small balance that never clears, ageing month by month. A report with dozens of small, old balances across many debtors usually means short payments that were never resolved, either by a credit note or by chasing the difference. Each one is small; together they can be a meaningful part of the funded ledger, and they are debts that will almost certainly never be paid in cash.

Why it matters to the financier

A financier’s prepayment percentage has to leave room for dilution. If a client’s dilution is 6.5% and the financier prepays 85%, there is a margin. If dilution rises to 15% and nobody notices, that margin has gone, and the facility is lending against money that will never be collected.

That’s why credit controllers matter here. They see the short payments, the unexplained deductions and the credit notes as they happen, often weeks before dilution shows up in a monthly figure.

What credit controllers should do

• Record the reason for every short payment. “Paid £4,320 of £4,800” is not enough; “£480 deducted for pallet charges” is.
• Ask for credit notes promptly. If a debtor says a credit is due, find out from the client whether it will be raised, and when.
• Watch for patterns. The same debtor short-paying every month, or credits appearing after month end, should be raised with the client manager.
• Look for the supplier relationship. A debtor that pays net amounts may also be a supplier. Ask.

Dilution rarely announces itself. It builds up in small amounts across many debtors. The teams that catch it are the ones who treat every unexplained short payment as a question worth answering.