What is the Accounting Rate of Return (ARR)?
The accounting rate of return, often called the ARR, is a way to determine whether spending money on a project or investment is a good idea. It looks at how much profit the project might make compared to its cost. The project is probably worth doing if the ARR percentage is high enough.
How the ARR Works
Imagine you have a lemonade stand. You need to buy lemons, sugar, cups, and signs to get started. All of this costs $50, which is your initial investment.
Let’s say you run your lemonade stand for a summer and make $200 in profit (the money you made minus your expenses). To calculate your ARR, you divide your profit ($200) by your initial investment ($50):
$200 profit / $50 investment = 4 = 400%
Your ARR is 400%. This means for every dollar you put into your lemonade stand, you get 4 dollars back. That’s an excellent return!
The ARR Formula
In general, the formula for ARR is:
ARR = (Average Annual Profit / Initial Investment) x 100
Where:
- Average Annual Profit is the total profit divided by the number of years
- The initial investment is the total setup costs of the project
An Example of Using ARR
Let’s look at a more prominent example. Imagine a company is considering buying a new machine for $1,000,000. They expect this machine to bring in $250,000 in profit each year for the next 5 years.
First, we calculate the total profit: $250,000 per year x 5 years = $1,250,000 total profit.
Then, we calculate the average annual profit: $1,250,000 total profit / 5 years = $250,000 average annual profit
Now we can calculate the ARR: ($250,000 average annual profit / $1,000,000 initial investment) x 100 = 25%
The ARR for this project is 25%. On average, the company expects to get 1.25 dollars back for every dollar invested in the machine each year.
Advantages of Using the ARR
Simple to Calculate
One of the main advantages of ARR is that it’s effortless to calculate. You only need to know the initial investment and the average annual profit, making it a quick way to evaluate potential investments.
Easy to Understand
The ARR gives you a percentage that is easy to understand and compare. If Project A has an ARR of 20% and Project B has an ARR of 15%, it’s clear that Project A is expected to be more profitable.
Focuses on Profitability
The ARR directly measures the profitability of a project. This is what most investors care about the most. By calculating the ARR, you can see which projects will likely generate the most profit for the invested money.
Disadvantages of Using the ARR
Ignores the Time Value of Money
One of the main drawbacks of the ARR is that it doesn’t consider the time value of money. In other words, it treats a dollar earned today like a dollar earned five years from now. A dollar today is worth more because it could be invested and earn interest over those five years.
It doesn’t Consider Cash Flow Timing.
The ARR also doesn’t look at when the profits come in. For example, Project A might have a higher ARR than Project B, but if most of Project A’s profits come in later years, Project B might be the better choice.
Ignores Risk
The ARR calculation doesn’t factor in the risk of the investment. A project with a high ARR might seem attractive, but it might not be the best choice if it’s also hazardous. Investors generally expect a higher ARR for riskier projects.
ARR vs. Other Metrics
ARR vs ROI
Return on Investment (ROI) is another popular metric for evaluating investments. Like ARR, it measures an investment’s profitability. However, ROI uses the total profit rather than the average annual profit.
ROI = (Total Profit / Initial Investment) x 100
ROI is generally better for evaluating shorter-term, one-time investments, while ARR is better for longer-term, ongoing projects.
ARR vs IRR
The Internal Rate of Return (IRR) is a more complex metric that considers the time value of money. It calculates the discount rate that would make the net present value of all cash flows (both positive and negative) equal to zero.
The IRR is generally considered a more accurate measure of an investment’s profitability, but it’s also more difficult to calculate. It requires estimating the cash flows for each year of the project.
ARR vs. Payback Period
The payback period is the amount of time it takes for the profits from an investment to cover the initial costs. It’s calculated by dividing the initial investment by the annual cash flow.
Payback Period = Initial Investment / Annual Cash Flow
The payback period helps understand how long it will take to recoup your investment, but it doesn’t measure the overall profitability as ARR does.
When to Use the ARR
The ARR is most useful when:
- You’re evaluating long-term projects with ongoing profits and costs
- You want a quick and easy way to compare the profitability of different projects
- The projects you’re comparing have similar timelines and risk levels
Limitations of the ARR
While the ARR can be a helpful tool, it’s essential to understand its limitations:
- It doesn’t account for the time value of money
- It ignores the timing of cash flows
- It doesn’t adjust for risk
- It can be misleading for projects with large fluctuations in annual profits.
Because of these limitations, the ARR should not be the only metric to evaluate an investment. It’s best used with other metrics like ROI, IRR, and payback period to get a more complete picture.
To round off
The Accounting Rate of Return is a simple way to measure the profitability of an investment or project. By comparing the average annual profit to the initial investment, it provides a clear percentage return that is easy to understand and compare.
However, the ARR’s simplicity is also its main drawback. It doesn’t account for influential factors like the time value of money, cash flow timing, or risk. As such, it should be used cautiously and with other metrics.
Despite its limitations, the ARR remains a popular and valuable tool for quickly evaluating and comparing long-term, ongoing projects. Understanding how to calculate and interpret the ARR applies to a person or investor.
