How to Calculate Credit Sales Using Accounts Receivable Chron com

Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. He is the sole author of all the materials on AccountingCoach.com. However, you can also generate revenue from other activities like the sale of plant machinery, etc. So, Net Sales is calculated by subtracting the following components from the Gross Revenue of your business. K.A. Francis has been a freelance and small business owner for 20 years. She has been writing about personal finance and budgeting since 2008.

Remember, the trade discount allowance reduces your total sales to represent the actual price that your consumers pay. The average collection period is a metric that measures a company’s efficiency at converting sales on credit into cash on hand. The average collection period measures the amount of time necessary for a company to obtain cash payments from customers.

What Is a Contra Account & Why Is It Important?

Many firms sell items to customers on credit or advance a product with the expectation that payment will be made soon after. We should establish from the outset the fact that, depending on the industry, many companies’ sales are sold with terms of payment (credit sales), typically ranging from 30 to 90 days. During the month of May, Company Z issued $10,000 in refunds, because several items were damaged during shipment and one item was the wrong size, so the customer could not use it.

• The term may arise when a company has a particularly loose approach to credit.
• For example, if terms stipulate payment within 30 days, the business would aim to collect within 20 days.
• The company received $1M of product returns, and provided allowances of $500K.
• So, Net Sales is calculated by subtracting the following components from the Gross Revenue of your business.

It is important for a company’s liquidity and cash flow that accounts receivable be collected—or turned into cash—in a timely fashion. Such a discount term means that you offer a 2% discount to your customers. Only if they make payment within 15 days of a 30 day invoice period.

What is Credit Sales?

She taught Accounting, Management, Marketing and Business Law at WV Business College and Belmont College and holds a BA and an MAED in Education and Training. He is also an educational consultant who coaches students to equip with relevant knowledge on entrepreneurship and helps them to set up small-scale and freelance businesses. Each of the inputs in the formula is described in more detail below.

Because Accounts Receivable are considered current assets, it’s good to know how much potential income the receivables are worth. It is also a good way to determine the ratio of cash-to-credit customers. This figure is important for a company that is considering seeking outside financing. For example, the turnover of XYZ for a recent month was ​$900,000​. Of this amount, the organization has received ​$600,000​ in cash at the time of purchase, and the rest was on credit. A customer purchased a product worth ​$20,000​ on credit, then returned it, stating that it has a defect.

Closing Entries, Sales, Sales Returns & Allowances in Accounting

These include direct expenses, indirect expenses, and capital expenses. Your income statement showcases the financial progress of your business during a specific period. Furthermore, the profit and loss statement consists of the unchanging sales and expenses categories. These categories include Net Sales, Cost of Goods Sold, Gross Margin, Selling and Administrative Expenses, and Net Profit.

• The Net Profit is the difference between your sources of revenue and expenses related to such revenue.
• Different types of businesses allow for varying amounts for sales return.
• If so, the accountant will need to back out these returns and allowances from the calculation.
• After deducting the $80,000 in cash sales, Company Z has $105,000 in credit sales.
• For example, the turnover of XYZ for a recent month was ​$900,000​.
• After this deduction, the total sales for May are $185,000 ($190,000 minus $5,000).

This amount would reduce the total number of cash sales, if the customer has already paid for the item or if the accounts receivable balance was from a credit customer. This reduces the total sales to $190,000 ($200,000 in total sales, minus $10,000 in returns). The net amount of gross sales on credit minus the sales returns, sales allowances, and sales discounts which pertain to the sales on credit. Once you deduct sales returns, discounts, and allowances from gross sales, the remaining figure is your net sales. Typically, a firm records gross sales followed by allowances and discounts.

The organization has also granted a sales allowance of ​$5,000​ to another customer due to an error that occurred while generating the invoice. Thus, using the accrual method of accounting you can recognise revenue from sales the moment you send invoices to your customers. You do not have to wait for the cash payment to recognise sales in your books of accounts. This means your total business revenues may reduce on account of returns, discounts, and allowances. Therefore, you need to adjust such items to compute net sales for your business. At the end of the year, the company had total sales of $15M, of which $12M related to sales to the major credit customer.

Let’s assume a manufacturing company has a major customer who purchases a significant amount of product every year. When the customer starting doing business with the manufacturer, they requested credit terms, so they could purchase product on credit and pay for it at a later date. This customer is the only customer with credit terms from the manufacturer and all other customers pay for product at the time of sale. Until the customer pays the company the amount owed in cash, the value of the unmet payment sits on the balance sheet as accounts receivable (A/R). Credit sales are recorded when a company has delivered a product or service to a customer (and thus has “earned” the revenue per accrual accounting standards).

Other things, such as the age of the account and any discounts, have to be considered. A potential problem with this calculation is that some of the sales returns and allowances may be related to sales that were originally paid in cash (not with a credit sale). If so, the accountant will need to back out these returns and allowances from the calculation. In this case, when an organization establishes credit terms with a customer and the customer uses the credit to purchase the product or service offered by the company, this is deemed to be a credit sale. Therefore, net credit sales of the company is $1,000,000 after considering the effect of sales return and sales allowances given to the customers.

• Because Accounts Receivable are considered current assets, it’s good to know how much potential income the receivables are worth.
• Net credit sales refer to the worth of sales on credit after deducting the sales returns and sales allowances.
• The organization has also granted a sales allowance of ​$5,000​ to another customer due to an error that occurred while generating the invoice.

Management uses this figure to track receivables and analyze how quickly customers are paying off their accounts. For example, this concept is used in the accounts receivable turnover https://accounting-services.net/what-are-net-credit-sales/ ratio as well as the days sales outstanding ratio. Companies whit higher NCS figures generally tend to ones with looser credit policies that allow many more customer access to credit.

Recording Net Credit Sales on Financial Statements

The only difference between the net sales and the NCS, are the payment methods used by the customer. Net credit sale is calculated as credit sales made to customers less sales return less the allowances if any. Net credit sales increase the liquidity as the debtors are considered the liquid asset. But business organizations try to make credit sales to the persons from whom there is no or less risk of being the default. For companies with a high percentage of credit sales, the average collection period may give a better indication of how successfully the company is converting its credit sales to cash.

• Let’s assume a manufacturing company has a major customer who purchases a significant amount of product every year.
• Thus, the total aggregate downward adjustment to the gross sales made on credit is $4 million, which we’ll subtract from our gross sales of $24 million to arrive at a net amount of $20 million.
• An example of a sales allowance is the allowance granted to a customer who purchased a product at a higher price due to a pricing error.
• Calculating credit sales, using accounts receivable, isn’t quite as simple, as adding up all of the receivables during a specific time frame.
• You do not have to wait for the cash payment to recognise sales in your books of accounts.