When it comes to business longevity, consistent cash flow, effective inventory management, and proper financial planning are critical. This means that you must have good control over your accounts receivable (the money customers owe to your business based on the expected selling price of your products).
While there are many different metrics that should be studied when managing both your inventory and accounts receivable, your net realizable value, NRV, is one of the most important. This is because it helps you to determine the value of your accounts receivables and inventory value.
This article will help business owners or those in charge of managerial accounting tasks better understand their net realizable value. It will define what NRV means, its importance, how to calculate it, and how NRV is used more generally.
So, if you're looking for an effective and reliable accounting method that you can use to calculate the net realizable value of your accounts receivable, read on.
What is Net Realizable Value (NRV)?
Net Realizable Value NRV is a commonly used technique for valuing assets based on how much money it will generate upon its eventual sale. In short, it measures the liquid value of a receivable account or inventory.
Net Realizable Calculations can help business owners determine how much new sales and revenue can be expected from their current assets. To calculate your net realizable value, you must subtract the estimated cost of selling costs (the expenses incurred in making the asset market-ready, alongside product shipping or transportation cost) from its expected sale price. This figure will help you to determine the maximum amount of cash you can generate from an asset.
From an accounts receivables perspective, your net realizable value helps you to determine the market value of an asset or how much money you can expect to collect from a customer. Regarding inventory management, your net realizable value determines the inventory's liquidation value.
How does NVM interact with the GAAP?
There are many official regulations that businesses must adhere to when it comes to accounting reporting. However, the GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards IFRS) are the primary guidelines for financial accounting.
They require accountants to implement the principle of conservatism when making value calculations. This interacts with your net realizable value calculations, as you must make the most conservative estimates when calculating your asset values. This means that for accounts receivables, your calculations should be adjusted to reflect customer payment issues, discounts, or write-offs.
When conducting an inventory assessment, this conservative method of accounting requires accountants to estimate the cost of selling an asset in the most financially conservative manner possible instead of inflating the value of an asset to your benefit.
In short, when calculating your net realizable value, it is considered best practice to be as conservative with your estimates as possible, meaning that you must not overstate the value of an asset.
What are the use cases for Net Realizable Value?
When it comes to the practical application of NRV in your business, there are three primary cases in which it should be employed:
- Net realizable value of accounts receivable. When assessing the value of an accounts receivable balance, a company's net realizable value is used to determine how much money they can expect to collect from customers. As you must use a conservative method when calculating this figure, an allowance for doubtful accounts should also be considered. This means you'll need to estimate potential bad debt (money that is owed to your business but is no longer recoverable) and remove this bad debt expense from your total net realizable value NRV.
- Net realizable value of Inventory. Your net realizable value can help you with effective inventory management by helping you understand the maximum amount of cash you can generate through your inventor. As with the net realizable value of accounts receivable, the principle of conservatism applies here, too. This means that the direct costs associated with selling an asset should also be considered when evaluating the total value, such as the preparation cost or price of materials used in the production process. Remember, maintaining a conservative approach is crucial.
- Cost Accounting. Cost accounting is the process of internally evaluating the cost of producing and selling products. Net realizable value is, therefore, used to determine how much money a company can collect from its inventory once the total production costs and any potential losses have been deducted from the equation.
As evidenced above, net realizable value is a vital tool for making informed decisions about the performance of your accounts receivables and the value of assets and your inventory. It can also be used in cost accounting so that you can understand the profitability of producing and selling products.
The data gathered through your net realization value calculations can help you to improve your bottom line while also drawing attention to mistakes you are making in your business's processes.
What can Net Realizable Value tell you about your business?
Now that you've got a clearer understanding of the practical applications for net realizable value, let's take a closer look at what these figures can tell you about your business. After all, you can then use this information to action necessary changes that will take your company to the next level.
Your net realizable value:
- Highlights the creditworthiness of your clients. Having a solid understanding of the net realizable value of your accounts gives you a reasonable estimate of how much money you can expect from customers. This, in turn, can provide you with valuable insight into the overall creditworthiness of your clients and help you assess their ability to pay in the future.
- Highlights poor payment behaviour. If you have to consistently reduce your NRV calculations by an allowance for the same doubtful accounts on multiple occasions, it's a sign you might have some problematic customers. This could mean that you need to update your collections and billing processes or find new ways to incentivise prompt payments.
- Reveals potential losses associated with selling your inventory. Calculating your net realizable value for your inventory will also give you an accurate picture of the potential losses associated with selling these goods or products. This inventory valuation method can help determine whether it's worth investing in certain products or services and will inform strategic decisions about pricing, production, and marketing. For example, it could be that you chose to abandon a specific product range due to consumer habits or general disinterest. While this may seem concerning, it ensures that you can generate profits through other products instead, which can increase the value of inventory.
- Identifies operational risks. As your net realizable value helps you to evaluate the costs associated with the production process, it can bring to light any operational risks associated with producing and selling products or offering credit to specific customers. This information can help you to pinpoint areas where your business may be losing money and identify potential improvements.
The data gathered from a net realizable value calculation can form a vital foundation for assessing the efficacy of your accounts receivable process and inventory management systems. In short, this valuation method can help you to make informed decisions about how best to manage your inventory accounting, business finances, and resources.
Now that you understand the importance of net realizable value, it's time to look at how you calculate it using the net realizable value formula.
How to Calculate Net Realizable Value
Fortunately, calculating net realizable value is relatively straightforward. This means that you do not need to use a net realizable value calculator in order to gain access to this vital information. In fact, the net realizable value formula is divided into just three steps.
Step one: Determine the asset values.
The first step of the process is determining your asset's fair market value (FMV). The fair market value of an asset refers to its estimated value in an "open and unrestricted market." This refers to a market wherein there are no sales restrictions in place, and as such, is dependent on a variety of factors, such as the current market demand or market value of similar assets and products.
Step two: Deduct expected disposal costs.
When calculating NRV, you also need to factor in selling costs or disposal costs. This could include marketing and advertising costs, shipping or transportation costs, as well as any legal fees associated with the sales process. You can determine the expected cost of these expenses by taking a look at your financial statements or balance sheet.
If you are calculating the net realizable value of an account, you will deduct the allowance for doubtful accounts from the total cost at this time to ensure you are maintaining a conservative approach.
Step three: Calculate the Net Realizable Value NRV.
Now that you have access to both of the figures outlined above, it is time to deduce your selling cost or allowance for doubtful accounts from your expected selling price or FMV. This figure is your net realizable value.
NRV formula
The net realizable value formula used in the three-step process outlined above will look like this:
Net Realizable Value = Fair Market Value - Expected Disposal Cost/Losses from Doubtful Accounts.
Calculating NRV is a reasonably simple and straightforward process, but it's one that you must get right. After all, it's integral to your understanding of your business's financial performance.
Net Realizable Value Examples
Now you've learned how to calculate net realizable value for your business, let's take a look at some examples that expand on how your NRV would be calculated in a real-life scenario:
Example 1 - Calculating the NRV of an inventory asset
Let's imagine that you run an electronic company and that you have a large number of portable battery packs in your inventory. The FMV of the battery packs is $500. Based on the historical cost of your marketing and advertising efforts, you expect to spend around $50 on these tasks. In this case, you can use the following net realizable value formula:
Net Realizable Value = Fair Market Value - Expected Costs.
= $ - $50
= $450
Example 2 - Calculating the NRV of an account
Next, let's imagine that your business has an accounts receivable balance of $2,000. However, your company has reason to believe that 5% of the balance is uncollectable due to poor payment behavior from some customers. In this case, the net realizable value formula would be used as follows:
Net Realizable Value = Fair Market Value = Losses from Doubtful Accounts
= $2,000 - ($2,000 x 5%)
= $1, 900
Net realizable value calculations are a simple yet incredibly effective way to determine your potential losses when selling inventory or offering credit to customers and clients. Having an awareness of your net realizable value figure means you're able to make more informed decisions relating to product/service sale price, production, marketing, and more.
As evidenced in example 2, the net realizable value formula can also draw attention to poor payment behavior from customers. While this could prompt changes within your billing processes, it also means that you can make more informed decisions on who to extend credit to moving forward or on how you'd like to manage your future receivables.
Net Realizable Value as part of effective credit control
Knowing your net realizable value is about more than being able to determine the expected selling price of an asset, product, or service. After all, in addition to helping you set a realistic selling price, it can also form part of your larger credit control strategy, especially when tracking customer payment behaviour.
However, if you're looking to curate a more holistic and viable credit control strategy, there are many other strategies you can combine this practice with. For example, you should also endevor to set up comprehensive payment terms, use automation, and conduct regular credit checks. All of the above steps will soon be reflected in your income statement, giving you the opportunity to improve your financial situation - without having to sell your products at a lower cost in order to facilitate higher sales.
To find out more about how Chaser can be the foundation of your credit control strategy and help you get paid, on average, 16 days faster, contact Chaser's team today or start your no-obligation 14-day free trial today. Chaser can also be used to help you determine the best net realizable value method for your business.
