When developing the Credit Management Benchmark, I made the initial assumption that a high credit note to invoice ratio is not a good thing. After all, payments on invoices are normally delayed until credit notes are received and processed. There are also the costs associated with preparing, approving, recording, distributing and allocating credit notes.
However, there are some circumstances in which a high ratio is normal practice.
Understanding the Credit Note to Invoice Ratio
This ratio is simply the number of credit notes issued as a percentage of invoices generated. In the diagram above, the lowest percentage of credit notes issued is 0%. This was mainly for small, consultancy type businesses, with low volumes of invoices.
My expectation at the outset was that a good ratio would be around 5%.
In fact, the median value is 3% (the median is the mid point, i.e. 50% of participants in the Credit Management Benchmark have over a 3% credit note to invoice ratio, while 50% have a lower credit note to invoice ratio).
I was somewhat surprised that the average was 7% as this was higher than I had expected, but still not a million miles away from my original expectation of around 5%.
The maximum rate of 50% came as a complete shock to me. This means that for every 2 invoices, a credit note is issued. How could this be? How does it make any sense?
Why are Credit Notes issued?
Much of my career has been spent working with companies that distribute products or deliver services. In these types of businesses, credit notes are normally issued for reasons such as the following:
- Short shipments
- Defective products
- Incorrect pricing
- Incorrect customer invoiced
In these circumstances, credit notes are being issued to correct mistakes and this accounts for my expectation that a good credit note to invoice ratio would be around 5%, but should in fact be much lower.
Credit Notes for other purposes
It is clear from the results of the Credit Management Benchmark that credit notes are issued for reasons other than correcting mistakes. I spent time exploring the reasons for this with participants in the benchmark process and came to understand that credit notes have other uses.
For example, a number of suppliers to major multiples (the major supermarket chains), issue credit notes as part of their Long Terms Agreements (LTA’s), that is the rebates that they provide to customers who achieve specific sales volumes.
In another industry, prices for products start off high and reduce over time. Credit notes are issued to reflect the reductions in prices which may occur after invoices have been issued.
Does this mean that sales can sometimes be over-stated?
Absolutely. If rebates are going to be provided to customers, or price reductions given after invoices have been issued, then sales figures are inflated. I am aware that most companies put credits for LTA’s or price reductions through before the end of the financial year, but it does open the door to potentially misleading sales information if the credits are not put through in a timely manner.
So what does your credit note to invoice ratio mean?
I think that it has to be seen in the context of the industry in which you operate. It is clear that some industries will have a higher ratio than others because of established practice in those industries.
Therefore, the questions to ask are:
- Is my credit note to invoice ratio as low as it could be?
- What steps can our business take to lower it?
- How does it compare to similar businesses?
- What is your ratio?
Why not participate in the Credit Management Benchmark? It will allow you to compare your credit function against your peers.
It takes about 15 minutes to complete and all information is strictly confidential.