What is the accounting rate of return – ARR?
The accounting rate of return (ARR) is the percentage of return expected on the investment or the asset compared to the initial investment cost. ARR divides the average income of an asset by the initial investment of the business to obtain the ratio or return that can be expected over the life of the asset or related project. ARR does not take into account the time value of money or cash flow, which can be an integral part of maintaining a business.
The formula for ARR
How to Calculate the Accounting Rate of Return – ARR
- Calculate the annual net profit from the investment, which could include income minus the annual costs or expenses of implementing the project or investment.
- If the investment is a capital asset such as a tangible capital asset, subtract any depreciation expense from the annual income to realize the annual net profit.
- Divide the annual net profit by the initial cost of the asset or investment. The result of the calculation will give a decimal. Multiply the result by 100 to display the return percentage as an integer.
What does ARR tell you?
The book rate of return is a useful measure of capital budgeting for a quick calculation of the profitability of an investment. The RRA is mainly used as a general comparison between several projects to determine the expected rate of return for each project.
ARR can be used to decide on an investment or acquisition. It takes into account all possible annual expenses or depreciation associated with the project. Depreciation is an accounting process by which the cost of an asset is spread or expensed each year over the useful life of the asset.
Amortization is a useful accounting policy that eliminates the need for businesses to spend the full cost of a large purchase in the first year, which enables the business to immediately profit from the asset. , even during his first year of service. In calculating the ARR, the amortization charge and all annual costs must be subtracted from the annual income to produce the net annual profit.
Key points to remember
- The ARR is useful in determining the percentage of annual return on a project.
- The ARR can be used when reviewing multiple projects because it provides the expected rate of return for each project.
- However, ARR does not distinguish between investments that generate different cash flows during the life of the project.
Example of use of the accounting rate of return – ARR
We are considering a project that has an initial investment of $ 250,000 and that should generate revenues for the next five years. Here are the details:
- initial investment: $ 250,000
- expected revenue per year: $ 70,000
- deadline: 5 years
- Calculation of ART: $ 70,000 (annual revenue) / $ 250,000 (initial cost)
- ARR = .28 or 28% (.28 * 100)
The difference between ARR and RRR
As noted, the ARR is the percentage of annual return on an investment based on its initial cash outlay. However, the required rate of return (RRR), also known as the obstacle rate, is the minimum return that an investor will accept for an investment or project, which compensates for a given level of risk.
The RRR can vary from one investor to another because the investors have different risk tolerances. For example, an investor unwilling to take risks would likely require a higher rate of return on the investment to offset any risk associated with the investment. It is important to use multiple financial metrics, including ARR and RRR, to determine if an investment is worth it.
Limits on the use of the accounting rate of return – ARR
The ARR is useful in determining the annual rate of return as a percentage of a project. However, the calculation has its limits.
ARR does not take into account the time value of money (TVM). The time value of money is the concept that the money available today is worth more than the same amount in the future because of its earning potential. In other words, two investments could generate unequal annual income flows. If one project generates more income in the first years and the other project generates income in the following years, ARR does not assign a higher value to the project that generates profits earlier, which could be reinvested to earn more silver.
The accounting rate of return does not take into account the increased risk of long-term projects and the increased uncertainty associated with long periods.
In addition, ARR does not take into account the impact of the timing of cash flows. Suppose an investor is considering a five-year investment with an initial disbursement of $ 50,000, but the investment does not generate any income until the fourth and fifth year. The investor should be able to withstand the first three years without any positive cash flow from the project. The ART calculation would not take into account the lack of cash flow in the first three years.