Net realisable value (NRV) | Formula and calculation

Effective inventory and accounts receivable control are critical for most businesses to ensure consistent cash flow. Net realizable value (NRV) is a vital metric to determine the value of a company’s inventory or accounts receivable.

If you're not familiar with the term, don't worry. In this article, we'll define what NRV means, its importance, use cases, and how to calculate it and provide some examples to make it easier to understand.

So, if you're looking for an effective account method to calculate the net realisable value of accounts receivable, read on.

What is Net Realizable Value (NRV)?

Net Realizable Value is a commonly used valuation method to assess how much an asset would generate upon its sale. It measures the liquid value of a receivable account or inventory. NRV calculations help business owners determine how much new sales and revenue can be expected from their current assets.

The calculation for net realisable value subtracts the estimated cost of selling an asset (such as expenses incurred in making it market-ready) from its expected selling price. This calculation attempts to determine the maximum amount of cash a company can generate from an asset if it were to be sold.

From an accounts receivable perspective, NRV helps measure the amount of money a company can actually expect to collect from a customer. In inventory management, NVM determines the inventory’s liquidation value.

How does NVM interact with the GAAP?

The GAAP (generally accepted accounting principles) and IFRS (international financial reporting standards) are the primary guidelines for financial accounting. As part of those guidelines, they require accountants to implement the principle of conservatism when making value calculations.

This interacts with NRV as it requires accountants to make the most conservative estimates when calculating the NRV of an asset. This means that for accounts receivable, expected collection amounts should be adjusted to reflect any potential customer payment issues, discounts, or write-offs.

Regarding inventory assessment, the principle of conservatism requires that accountants estimate the cost of selling an asset in the most financially conservative manner possible.

In short, when calculating NRV, it is considered best practice to be as conservative with your estimates as possible.

What are the use cases for Net Realizable Value?

When it comes to the practical application of NRV, there are three primary uses cases in which it should be employed:

• Net realisable value of accounts receivable - When assessing the value of an accounts receivable balance, NRV is used to determine the estimated amount of money a company can expect to collect from customers. As per the principle of conservatism, an allowance for doubtful accounts should be considered, reducing the total receivable balance by estimating potential bad debt.
  
  
• Net realisable value of Inventory - As part of effective inventory management, NRV determines the maximum amount of cash a company can generate from its inventory. As with the net realisable value of accounts receivable, the principle of conservatism applies here, and the estimated cost of selling an asset should be considered when evaluating total value.
  
  
• Cost Accounting - Cost accounting internally evaluates the cost of producing and selling products. Net realisable value is used to determine how much a company can collect from its inventory after subtracting the cost of production and any potential losses related to selling it as part of that equation.

As you can see, NRV is a vital tool for making informed decisions about the performance of your accounts receivable and the value of your inventory. It can also be used in cost accounting to better understand the profitability of producing and selling products.

Let's look at what NRV calculations can tell you about your business's processes and how you can use that data to improve your bottom line.

What can NVM tell you about your business?

Now that you've got a clearer idea about the practical uses for net realisable value, let's take a closer look at what this calculation can tell you about your business:

• It shows you the creditworthiness of your clients - Having a solid understanding of the net realisable value of your accounts receivable will tell you how much money to expect from customers. This could provide valuable insight into the creditworthiness of your clients and help you assess their ability to pay in the future.
  
  
• It helps highlight poor payment behaviour - If you consistently reduce your NRV calculations by an allowance for the same doubtful accounts on multiple occasions, it's a sign that you might have some problematic customers.
  
  
• It reveals potential losses associated with selling inventory - Calculating the net realisable value for inventory can give you an accurate picture of the potential losses associated with selling it. This can help you evaluate whether or not it's worth investing in certain products or services and will inform strategic decisions about pricing, production, and marketing.
  
  
• It helps identify operational risks - By evaluating the cost of production, NRV can help you identify operational risks associated with both producing and selling products and offering credit to specific customers. This information can help you pinpoint areas where your business may lose money and identify potential improvements. 
  
  

The data produced by NRV calculation can form a vital foundation for assessing the efficacy of your accounts receivable process and inventory management systems. By understanding and analysing the data, you can make informed decisions about how best to manage your business's finances and resources. 

Now that you understand the importance of NRV let's look at exactly how you calculate it.

How to calculate Net Realizable Value

Calculating NRV is a simple three-step process that we'll walk you through, step by step:

Step one - Determine the asset’s fair market value (FMV) - The FMV of an asset is its estimated value in an open and unrestricted market. This will depend on the condition and other relevant factors, such as the current market demand for similar assets.

Step two - Deduct expected disposal costs - When calculating NRV, you need to consider the cost of selling or disposing of the asset. This could include things like marketing and advertising costs, as well as legal fees associated with the sale. If you are calculating the NRV of an account, this is where you could deduct the allowance for doubtful accounts.

Step three - Calculate the NRV - Once you have the FMV, all you need to do is deduce your calculated expected disposal costs or allowance for doubtful accounts from your FMV to get your NRV.

NRV formula

The formula you would use in step three to calculate your NRV would look like this:

NRV = Fair market value - expected disposal costs/allowance for doubtful accounts

Calculating your NRV is reasonably simple and straightforward, but it's essential to understanding your business’s financial performance.

Net Realizable Value Examples

Now that you understand how to calculate your NRV, let's look at some examples that expand on how NRV would be calculated in a real-life scenario:

Example 1 - Calculating the NRV of an inventory asset

In this example, an electronics company has portable battery packs in its inventory. The FMV of the battery packs is $500. However, the company estimates that its marketing and advertising costs would be $50. In this case, we can calculate the NRV as follows:

NRV = Fair market value - expected costs

= $ - $50

= $ 450

Example 2 - Calculating the NRV of an account

In this scenario, a business has an accounts receivable balance of $2,000. However, the company has reason to believe that 5% of the balance is uncollectible due to poor payment behaviour from some customers. In this case, we can calculate the NRV as follows:

NRV = Fair market value - allowance for doubtful accounts

= $2,000 - ($2,000 x 5%)

= $1,900

NRV calculations are a simple but effective way to determine your potential losses when selling inventory or offering credit to customers. Being aware of the net realisable value of your assets helps you make informed decisions about pricing, production, and marketing.

As you can see from the second example, calculating the NRV of accounts receivable can also highlight poor payment behaviour from customers. Using this information, you can make informed decisions about who to extend credit to and how to manage your future receivables. 

NRV as part of effective credit control

Using NRV to track customer payment behaviour is just one part of a larger credit control strategy.

When combined with other practices, such as setting up comprehensive payment terms, using automation, and conducting regular credit checks,  calculating the NRV of an account becomes part of a holistic credit control strategy.

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.