Net Sales
The term represents the money a company generates for an accounting period but after accounting allowances, discounts, and returns.
What Are Net Sales?
Net sales is an important financial metric for companies. It is sometimes called net revenue. The term represents the money a company generates for an accounting period but after accounting for 3 variables.
These 3 variables are
- Allowances
- Returns
- Discounts
Net sales depict a company’s income to a truer extent since deductions are already made in the calculation. A business can gauge its financial position by analyzing this figure. Using this metric, companies can learn about market trends and customer preferences.
So, the company can accordingly make changes and amend its marketing mix. Every so often, usually every quarter, companies must make an earnings call. This is to state whether the firm has beaten or missed the economy’s expectations.
One of the main numbers looked at in this process is net sales. As mentioned before, it can provide valuable information to the company, with trends and preferences. Keep in mind, though, that multiple figures are analyzed when making financial decisions.
Net sales are one of the chief ones.
However, there is another party with interest, the stakeholders. Since the indicator shows the company’s ability to make revenue, it is a great tool for understanding its market share and whether the company is profitable.
Along with a plethora of metrics, net sales allow stakeholders to decide whether to invest in the company or pull out. A comprehensive set of data must be analyzed before making a decision. Net sales are one component.
This article will cover the topic. Let’s understand the significance of the term.
Key Takeaways
- Net sales represent an entity’s income after deducting allowances, discounts, and returns from gross sales.
- Net sales = Gross sales - (Allowances + Discounts + Returns).
- Businesses use the figure to assess their financial position and customer behaviors.
- Stakeholders use the metric to evaluate companies and if they should invest.
- The equation can be manipulated to solve for the other variables.
Net Sales Components
The calculation involves 4 variables. First, take the gross sales, then subtract allowances, discounts, and returns.
The equation will look like this:
Net sales = Gross sales - (Allowances + Discounts + Returns)
Let’s go over what the variables are.
1. Gross sales
Gross sales are the unadjusted figure for total sales a company makes. Gross sales do not include any expenses. Gross sales = the sum of all sales. You can also manipulate the equation above to solve for gross sales.
The gross sales equation would be:
Net sales = Gross sales - (Allowances + Discounts + Returns)
2. Allowances
Sales allowances are the reductions in price for a product or service provided to customers. Companies allow such reductions in specific scenarios.
Some special cases are:
- Defects
- Late delivery
- Errors in billing
- Customers unhappy with products or services
Allowances are recorded as contra-revenue. This means that they reduce a business’s revenue figure.
Note
A contra-revenue account deducts items like discounts and returns from a company's total revenue to obtain the entity’s net revenue. The account offsets the total revenue figure.
Specifically, the revenue reduction is displayed in the books as a credit to accounts receivable and a debit to sales allowances. Thereby, the gross sales figure is adjusted.
The equation can be manipulated to solve for allowances.
The equation to obtain allowances would be:
Allowances = Gross sales - Net sales - Discounts - Returns
3. Discounts
Discounts occur when a customer makes a payment within a certain period since the issuance of the invoice. For instance, some transactions may include an option where if the customer pays within x amount of time, they will be given a y% discount.
If the customer takes the option and pays according to the conditions, then the discount amount is y. The journal entry would feature a credit to accounts receivable and a debit to sales discounts.
Note
Remember that discounts are used to ensure quick payment by the customer. This improves the business’s cash flow.
Here is the format for a sales discount:
5/10, net 60
This may look confusing. You might be asking why there is a fraction and what net means but don’t worry; this format is simple.
5 represents the 5% discount that can be taken. 10 represents the number of days the customer has to avail of the discount; that is, they must pay within 10 days to get a 5% discount. And the “net 60” means the full payment is due within 60 days.
Regardless of the discount option taken, the payment is due within 60 days.
Hopefully, that cleared up the format.
The equation to solve for discounts would be:
Discounts = Gross sales - Net sales - Allowances - Returns
4. Returns
This is the last variable in the equation. Sales returns are the process by which customers return products to the vendor. Returns could happen for various reasons, such as customer dissatisfaction, not meeting the customer’s needs ( for example: size of clothing), or a defective product.
Sales returns cause credit to accounts receivable. There is a debit made to sales returns. This debit reduces the company’s gross sales.
Here is the equation for returns:
Returns = Gross sales - Net sales - Allowances - Discounts
Net Sales and the Income Statement
It plays a part in the three main statements.
1. Income statement
It is usually recorded on the income statement. This statement’s purpose is to highlight the revenue and expenses of a company for a certain accounting period.
It is part of the revenue section. Companies should report their net and gross sales in the income statement to be most transparent. This displays how much deduction was made. This provides a clearer outlook for stakeholders than if only the net were reported.
On the income statement, it is part of the equation for gross profit. Gross profit is equal to net minus the cost of goods sold. Additionally, it influences operating income, which is equal to gross profit minus operating expenses.
Since the net sales are included in the calculation for gross profit, it is also relevant for operating income, which uses gross profit.
2. Balance sheet
The balance sheet lists out a company’s financial position by breaking down its assets, liabilities, and equity.
On the balance sheet, sales are not directly mentioned. Only the accounts receivable account and cash generated from it are utilized. Both of these values are relevant, so while the variable of interest is not directly mentioned, it is present indirectly in two ways.
3. Cash flow statement
The cash flow statement lists the cash inflows and outflows from operating, investing, and financing activities. Sales are a part of the operating activities section. It is used and then adjusted for accounts receivable and other accounts.
This arrives at the net cash flow from operating activities.
It is crucial to every company. They are a key metric for stakeholders. Performance, growth, and market share can be revealed through the reporting of it. It is interesting to see how each of the three financial statements uses it differently.
Calculating Net Sales
Here are some practice problems using the equation. Remember, the equation can be manipulated!
1. Bob’s Bakery had gross sales of $970,000 in 2021. The company issued sales allowances of $79,000, and customers returned products worth $45,000. What are Bob’s Bakery’s net sales? (No discounts are mentioned, so assume $0)
Net sales = Gross sales - Allowances - Discounts - Returns
Net sales = $970,000 - $79,000 - $0 - $45,000 = $846,000
Bob’s Bakery’s net sales are $846,000.
2. A pharmacy company reported gross sales of $1,000,000 for 2010 Q1. The cost of goods sold totaled $67,000. The company issued sales allowances of $100,000. Sales discounts of $34,000 were made. Customers returned products worth $89,000. What was the company’s gross profit?
Net sales = Gross sales - (Allowances + Discounts + Returns)
Net sales = $1,000,000 - ($100,000 + $34,000 + $89,000) = $777,000
Gross profit = Net sales - Cost of goods sold
Gross profit = $777,000 - $67,000 = $710,000
The pharmacy company’s gross profit in Q1 was $710,000.
3. Gloria’s Farm Nursery had gross sales of $400,000 in 2022. The company issued sales allowances of $124,000, discounts of $57,000 were made, and customers returned products worth $125,000. What are Gloria’s Farm Nursery’s net sales?
Net sales = Gross sales - (Allowances + Discounts + Returns)
Net sales = $400,000 - ($124,000 + $57,000 + $125,000) = $94,000
Gloria’s Farm Nursery’s net sales are $94,000.
Net Sales vs. Gross Sales
Here is a table that sums up the main differences between the net and gross sales.
| Net Sales | Gross Sales |
|---|---|
| The revenue, that is, the sales figure after making the appropriate deductions for allowances, discounts, and returns | Total revenue before any deductions are made |
| Net sales = Gross sales - (Allowances + Discounts + Returns) | Gross sales = Net sales + (Allowances + Discounts + Returns) |
| Represents a company’s revenue | Great for measuring sales volume |
| A more realistic view of an entity’s operations and ability to generate revenue | A more optimistic view of an entity’s performance |
Conclusion
Hopefully, this article helped you understand net sales.
Anyone interested in finance, accounting, or general investing should understand what this figure means. Businesses should be transparent in reporting this. It provides meaningful information to stakeholders.
It is fundamental to assessing a company’s revenue generation. Gross sales are great, but the net sales show how much the company walks away with. This is the true indicator of revenue.
If a company made a lot of money but had a lot of allowances, discounts, and returns, then they pocket very little. Therefore, even if their gross wealth was a lot, their net is very little and is concerning to stakeholders.
This is why transparency about it is important so that well-informed decisions can be made.
Remember the equation.
Net sales = Gross sales - (Allowances + Discounts + Returns)
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