Credit notes and dilution: what a rising rate tells you
Every credit note is a debt that will never be paid. Measured month by month, credit notes tell you how much of the ledger you fund is really collectable, and a rising rate usually arrives before any other warning.
On Business Audits · 30 September 2026 · 5 min read
A credit note reduces what a customer owes. Some are routine: goods returned, a price corrected, a volume rebate earned. Others are signs of trouble: invoices raised for goods never sent, disputes settled by writing the balance down, or a debt quietly removed because it will never be paid. For a financier, they all have the same effect. A pound of credit note is a pound of debt you may have funded that will not come back as cash.
The word for this is dilution: the share of invoiced sales that is reduced by anything other than payment. It is one of the most useful figures an audit produces, and one of the most often overlooked.
Measuring it
Dilution is credit notes raised in a period, divided by sales invoiced in the same period. Measure it monthly, and look at the trend rather than any single month.
| Month | Sales invoiced (£) | Credit notes (£) | Dilution |
|---|---|---|---|
| July | 412,000 | 8,240 | 2.0% |
| August | 398,500 | 9,165 | 2.3% |
| September | 405,000 | 14,580 | 3.6% |
| October | 421,000 | 22,734 | 5.4% |
| Four months | 1,636,500 | 54,719 | 3.3% |
Northfield Components Ltd, an illustrative client.
The four-month average of 3.3% looks unremarkable. The monthly figures tell a different story: dilution has more than doubled in a quarter. If the prepayment was set when dilution ran at 2%, the margin it leaves for credit notes has been used up.
What drives a rising rate
When dilution rises, the question is why. The answer is usually in the credit notes themselves, so ask for a list with the invoice each one reduces and the reason given.
- Returns and quality problems. A batch of faulty goods produces a cluster of credit notes against several customers in the same weeks. Check whether the problem has been fixed, or whether it is still producing returns.
- Pricing disputes. Credit notes for part of an invoice, against the same customer month after month, often mean the invoiced price is not the agreed price. The ledger is overstated every month until it is settled.
- Pre-invoicing reversed. An invoice raised before delivery is sometimes cancelled when the order is changed or the goods are not sent. A credit note for the full value, raised shortly after an invoice at month end, is worth testing against the delivery paperwork.
- Bad debts written off by credit note. Some businesses remove uncollectable balances this way rather than through a bad debt account. These are not dilution in the usual sense, but they reduce collectable debt just the same.
- Rebates and settlement discounts. These are legitimate but should be predictable. If they were not disclosed when the facility was set up, the prepayment may be too high.
Credit notes that are held back
A low dilution rate is not always good news. Credit notes can be withheld from the ledger to keep the funded balance up: the customer is told a credit is coming, and it is raised later or not at all. The debt stays on your ledger at full value while the customer plans to pay less.
Signs to look for:
- Debtors paying short. Remittances that pay invoices in part, with a deduction the ledger does not explain.
- Old balances that never move. An invoice in the three-month column whose debtor is otherwise paying on time.
- Credit notes clustered after month end. Raised in the first days of a month for invoices from the month before, after the funding calculation has been made.
- A trade with normal returns and no credit notes at all. Food, clothing and building supplies all have returns. A ledger in those trades with almost none is worth asking about.
A balances verification is the quickest test. A debtor expecting a credit will quote the lower figure.
What to do with the figure
Dilution feeds straight into how much you can safely advance. If you fund 85% of approved debt, the 15% retention has to absorb dilution, concentration and anything else that stops a debt being collected. When dilution rises from 2% to 5%, most of that margin is taken by credit notes alone.
Three practical steps:
- Track it every month, not just at audit. The client’s month-end sales and credit note totals are enough.
- Agree a covenant where the facility allows, so that a rising rate triggers a conversation before it becomes a loss.
- Ask for reasons, not just totals. A credit note list with the invoice and reason for each is a few minutes’ work for the client and tells you more than any ratio.
Reading credit notes at audit
At audit we take every credit note raised since the last visit, match each to the invoice it reduces, and group them by reason and by debtor. That shows whether dilution is spread across the ledger or concentrated on a few customers, whether the reasons given hold up, and whether any credit note reverses an invoice that was raised before the goods left. The result is a dilution figure you can compare with the last audit’s, and a short list of credit notes that need explaining.