For every business that sells goods or services on credit, accounts receivable is a vital part of the business. Accounts receivable (AR) is the money owed to a company by its customers for goods or services that have been delivered but not yet paid for. The management of accounts receivable is essential to the cash flow of any business, and it is a critical part of the accounting process.
In this article, we will be looking at how to calculate net accounts receivable. We will define what gross accounts receivable, allowances, discounts, and bad debts are, and explain their importance in calculating net accounts receivable.
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What is Net Accounts Receivable?
Net accounts receivable refers to the amount of money a business can expect to receive from its customers after deducting allowances, discounts, and bad debts from the gross accounts receivable.
Knowing how to calculate their net accounts receivable is critical for a business to have a clear picture of their overall financial performance, including:
- Cash flow management
Knowing the amount of money that the business can expect to receive from its customers helps it manage its cash flow effectively. It allows the business to plan and forecast its cash inflows, which is important for meeting financial obligations such as paying bills, payroll, and making investments.
- Credit policies
Net accounts receivable helps businesses assess the effectiveness of their credit policies. If a business has a high net accounts receivable, it may indicate that its credit policies are too lenient, and it needs to tighten its credit terms to reduce the risk of bad debts.
- Financial health
A business’s net accounts receivable is an important indicator of its financial health. A high net accounts receivable can indicate that the business is not collecting its outstanding invoices in a timely manner, which can result in cash flow problems and may indicate problems with the business’s operations or credit policies.
- Bad debt management
Knowing the amount of money that the business does not expect to receive from its customers (bad debts) helps it manage its bad debt portfolio. By identifying and monitoring potential bad debts early, the business can take appropriate action to recover the funds or write them off as losses, which can improve its financial position.
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How to Calculate Net Accounts Receivable?
Net accounts receivable is the amount that the company expects to receive from its customers after all allowances, discounts, and bad debts have been deducted from the gross accounts receivable. Calculating net accounts receivable involves deducting the total amount of allowances and discounts from the gross accounts receivable and adding the total amount of bad debts.
The formula for calculating net accounts receivable is:
Net Accounts Receivable = Gross Accounts Receivable – (Allowances + Discounts) + Bad Debts
where:
Gross Accounts Receivable – The total amount owed by customers for goods or services that have been sold on credit;
Allowances – The amount of money that the company has agreed to deduct from the invoice due to a problem with the product or service provided;
Discounts –The amount of money that the company has agreed to deduct from the invoice if the customer pays within a certain timeframe;
Bad Debts – The amount of money that the company does not expect to receive from customers due to their inability or unwillingness to pay.
For example, let’s say your business has a gross accounts receivable of $8,500, offered allowances and discounts totaling $950, and incurred bad debts of $1,500. To calculate the net accounts receivable, you would deduct the total amount of allowances and discounts from the gross accounts receivable ($8,500 – $950 = $7,550) and then add the total amount of bad debts ($7,550 + $1,500 = $9,050).
Below, we’ll look at the components of this calculation in more detail.
Calculating Gross Accounts Receivable
Gross accounts receivable refers to the total amount that a company has billed its customers for goods or services sold on credit. In other words, it is the amount that the company expects to receive from its customers. Calculating gross accounts receivable involves adding up all the outstanding invoices that have not yet been paid.
To calculate gross accounts receivable, you will need to follow these steps:
Step 1: Identify the invoices that have not been paid in full
The first step is to identify all the outstanding invoices that have not been paid in full. You can do this by reviewing your sales ledger or accounts receivable aging report. These reports will provide you with a list of all the invoices that are outstanding, along with the amount owed and the age of the invoice.
Step 2: Add up the outstanding invoices
Once you have identified all the outstanding invoices, you need to add up the total amount owed. This will give you the gross accounts receivable.
For example, let’s say your business has three outstanding invoices:
Invoice 1 – $5,000
Invoice 2 – $2,500
Invoice 3 – $1,000
The gross accounts receivable for your business would be $8,500 ($5,000 + $2,500 + $1,000).
Deducting Allowances and Discounts
Allowances and discounts are common in business transactions. They are used to adjust the amount owed by the customer for various reasons, such as damaged goods or early payment. It is essential to deduct these allowances and discounts from the gross accounts receivable to get an accurate picture of the amount the company expects to receive from its customers.
To deduct allowances and discounts from the gross accounts receivable, you will need to follow these steps:
Identify the allowances and discounts
The first step is to identify all the allowances and discounts that have been offered to customers. This information can be found in the sales ledger or accounts receivable aging report.
Calculate the total amount of allowances and discounts
Once you have identified all the allowances and discounts, you need to calculate the total amount. This can be done by adding up all the amounts that have been offered.
Deduct the total amount of allowances and discounts from the gross accounts receivable
The final step is to deduct the total amount of allowances and discounts from the gross accounts receivable. This will give you the net accounts receivable.
For example, let’s say your business has offered the following allowances and discounts:
Allowance 1 – $500
Allowance 2 – $250
Discount 1 – $200
The total amount of allowances and discounts offered would be $950. If we deduct this from the gross accounts receivable of $8,500, we would get a net accounts receivable of $7,550 ($8,500 – $950).
Adding Bad Debts
Bad debts are the amounts owed by customers that are unlikely to be paid. Bad debts can occur for a variety of reasons, such as the customer going bankrupt, disappearing, or refusing to pay. It is important to include bad debts in the calculation of net accounts receivable to get a more accurate picture of the amount the company expects to receive from its customers.
To add bad debts to the calculation of net accounts receivable, you will need to follow these steps:
Step 1: Identify the bad debts
The first step is to identify all the bad debts that the company has incurred. This can be done by reviewing the accounts receivable aging report and identifying invoices that have been outstanding for a long time or where the customer is unlikely to pay.
Step 2: Calculate the total amount of bad debts
Once you have identified all the bad debts, you need to calculate the total amount. This can be done by adding up all the amounts that are unlikely to be paid.
Step 3: Add the total amount of bad debts to the net accounts receivable
The final step is to add the total amount of bad debts to the net accounts receivable. This will give you the final net accounts receivable figure.
For example, let’s say your business has incurred bad debts of $1,500. If we add this to the net accounts receivable of $7,550, we would get a final net accounts receivable of $9,050 ($7,550 + $1,500).
Conclusion
Calculating net accounts receivable is an essential part of the accounting process for any business that sells goods or services on credit. It provides a clear picture of the amount that the company expects to receive from its customers after all allowances, discounts, and bad debts have been accounted for. It is important to note that the calculation of net accounts receivable should be done regularly to ensure that the company has an accurate understanding of its cash flow position. This will help the company make informed decisions about its cash management and credit policies.
