Credit memos, offsets and dilution

When a client sells on credit and invoices $100, the lender advances a percentage of that $100 on the understanding that the customer will pay it. Most of the time, it does. But some of that $100 never arrives as cash. It disappears into a credit memo for damaged goods, an offset against something the client bought from the customer, an early-payment discount, or a deduction the customer simply takes.

Each of these reduces what the receivables are really worth. Together they are called dilution, and every collector working financed receivables should understand them.

Credit memos

A credit memo cancels all or part of an invoice. Clients issue them for returns, damaged goods, pricing errors, short shipments and goodwill. A steady flow of credit memos is normal in most industries.

What matters to the lender is when they are issued and what they are issued against. A credit memo against an invoice financed six weeks ago reduces a receivable the lender has already advanced on. Credit memos clustered just after month end, issued against older invoices, suggest the receivables were overstated when the advance was drawn.

The opposite is also a warning sign. Receivables with almost no credit memos, in an industry where returns are normal, may mean credit memos are being held back to keep invoices eligible. That is the subject of the Withholding Credit Memos course in our fraud library.

Offsets

An offset arises when the customer is also a vendor to the client. Instead of paying in full, the customer nets what the client owes it against what it owes the client, and pays the difference.

For the lender, the problem is that the financed invoice is only worth the net amount. If a customer owes the client $25,000 and the client owes the customer $10,000, the receivable is worth $15,000 in cash, however the A/R aging shows it. Offsets are easy to miss because they rarely appear on the client’s receivables at all: the evidence sits in accounts payable, or in a remittance that pays less than expected.

Collectors usually spot offsets first, through short payments and remittances that “net out” something. Asking the client for its A/P aging, and comparing names against the A/R aging, finds the rest. Most lenders treat amounts subject to offset, sometimes called contra accounts, as ineligible.

Discounts and deductions

Early-payment discounts, volume rebates and retroactive allowances all reduce cash received. In some industries, large customers take deductions for promotions, late deliveries or compliance chargebacks, often without agreement and sometimes months after the invoice. These are especially common when selling to large retailers and grocery chains.

Measuring dilution

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

Dilution = credit memos, offsets, discounts and other non-cash reductions ÷ gross invoicing

For example, a client invoices $1,200,000 over a quarter. In the same period it issues $54,000 of credit memos, has $18,000 of offsets 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 A/R aging

Dilution often hides in the older buckets. An invoice that has been short-paid sits on the aging with a small balance that never clears, aging month after month. An A/R aging with dozens of small, old balances across many customers usually means short payments that were never resolved, either by a credit memo or by following up on the difference. Each one is small; together they can be a meaningful share of the financed receivables, and they are amounts that will almost certainly never be paid in cash.

Why it matters to the lender

A lender’s advance rate has to leave room for dilution. If a client’s dilution is 6.5% and the lender advances 85%, there is a margin. If dilution rises to 15% and nobody notices, that margin is gone, and the facility is advancing against money that will never be collected.

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

What collectors 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 memos promptly. If a customer says a credit is due, find out from the client whether it will be issued, and when.
• Watch for patterns. The same customer short-paying every month, or credits appearing after month end, should be raised with the account executive.
• Look for the vendor relationship. A customer that pays net amounts may also be a vendor. Ask.

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