It’s a nagging question for you as a business owner. Is the investment you made worth reinvesting, or should you have invested your capital in something else? An accounting rate of return, or ARR, can answer this question.
ARR measures the profitability of an investment. In accounting, there are various ways to measure the rate of return on investment. Each method uses different variables and may give varying results for a given set of facts.
They all measure how much value an investor receives from a given investment. But, what about using ARR in particular? Read on to learn more about ARR and how to calculate it.
What Is ARR?
The prospective success of an investment or purchase for a company is determined using the accounting rate of return calculation, or ARR. The ARR is a tool that enables an organization to assess whether a significant equipment purchase, an acquisition of another company, or another significant business investment is a financial win for the company.
If the accounting rate of return is higher than the benchmark, the investment is a worthwhile investment. If the accounting rate of return falls below the benchmark, the investment will not be.
The accounting rate of return (ARR) is a rate of return on an investment calculated using accounting assumptions. An example is the assumed rate of inflation and cost of capital rather than economic assumptions.
The accounting rate of return is an internal rate of return (IRR) based on accounting assumptions. And it can be useful to compare the profitability of investments with different uses. The ARR provides a corporation with a quick overview of the earning potential of a certain investment.
Compared to the needed rate of return which sets a minimum profit an investor desires, it is less focused on risk evaluation. Because it disregards the TVM or the time value of money, the ARR is also known as the simple rate of return. The TVM holds that money gained in the present is worth more than the same amount earned in the future.
How to Calculate ARR?
The accounting rate of return is the average rate at which all cash flows of a project get discounted for their time value. This can be calculated by adding the interest rate of the company, the cost of capital, and the expected inflation rate. This method is also based on the simplified net present value model.
The formula for calculating the accounting rate of return is as follows: the expected rate of return + expected inflation rate + cost of capital + expected net cash flows = ARR. It’s that simple.
Using ARR Calculations
You must first calculate the average annual profit growth, average expense on investment, and ARR before entering the data into the ARR calculation. The average yearly profit increase is calculated by analysts using the projected rise in annual revenues that the investment expects to offer throughout its useful life. The rise in annual expenses, including non-cash depreciation charges, are then subtracted.
By dividing the original book value of the investment by the value at the end of its life, you can determine the average investment cost. An example is when a company might want to invest $100,000 in a device that will net $150,000 over ten years. The machine’s salvage or residual value will be $10,000 after that.
Using the Formula for ARR
Most companies use the accounting rate of return formula to measure profitability. But, different companies use different accounting rates of return.
Because of that, you have to make sure you know what your company’s rate of return is. Some of the most common accounting rates of return are:
Standard Rate of Return
This method is the most used among manufacturers and other companies that have low levels of risk. The standard rate of return is the average of the rates of return on investment for the past three years. It can also be an average for the past 10 years if that period included both good and bad economic years.
Discounted Rate of Return
Companies that have high levels of risk using this method. The discount rate is the average of the rates of return on investment for the past three years or the average rates of return on investment during the same period for similar but less risky investments.
Weighted Average Rate of Return
This is like the discounted rate of return. The difference is that the expected cash flows get discounted at the rates of return earned on the individual investments. The weighted average is a weighted average of the rates of return earned on the separate investments in the project.
Limitations of Accounting Rate of Return
The accounting rate of return is a very good metric for comparing different investments from an accounting perspective. But, it is not good for comparing investments from a financial perspective.
The reason for this is that the accounting rate of return gets based on accounting assumptions such as the assumed rate of inflation and cost of capital rather than economic assumptions. The main problem with this method is that it does not consider risk.
This means that it does not take into account the possibility that an investment may not earn the expected rate of return. In other words, it does not take into account possible losses. As a result, it is not a good metric to measure the profitability of investments with different levels of risk.
Pros and Cons of Using ARR
The accounting rate of return is sometimes referred to as the average or simple rate of return. Comparing investment alternatives is not a good use of ARR because it is not a good tool for vetting specific projects. Although ARR can calculate returns on specific assets, it is not appropriate for comparing them.
The time worth of money is not taken into account by the accounting rate of return, so various investments may have different periods. The accounting rate of return is different from other used return metrics such as net present value or internal rate of return.
This is because it does not consider the cash flows generated by an investment. Net operating income is what the accounting rate of return focuses on.
This can be beneficial because net income is what many investors and lenders use to select an investment or make a loan. But, cash flow may be a more critical concern for the company’s managers. So, the accounting rate of return is not always the best method for evaluating a proposed investment.
The Formula for Capital Budgeting
Capital budgeting is the process used by companies to decide whether a project is worth investing in. The company estimates the cost and benefit of the project and then uses these figures to decide how much money it should invest in that project. The main formula for calculating capital budgeting is using the expected rate of return + expected inflation rate + cost of capital + expected net cash flows = capital budgeting.
Bottom Line: Should You Invest or Not?
Accounting rate of return is a method for identifying whether an expensive equipment purchase, merger, or other major business investment would be worth the cost. It is the net annual income divided by the capital expenditure.
If the accounting rate of return exceeds the smallest required rate of return for the company, the investment may be worth the expense. If the accounting return is below the benchmark, the investment will not be beneficial for the company.
The rate of return is one of the most important factors when making investment decisions. It is important to understand the difference between accounting rate of return and financial rate of return. This is because they each have different assumptions.
The accounting rate of return uses accounting assumptions such as the cost of capital, inflation rate, and cost of equity. The financial rate of return, on the other hand, uses economic assumptions such as risk-free rate and expected rate of return.
If you want to make a good decision, you need to know how each of these rates of return are calculated and how they differ from each other. Furthermore, you also need to know how to use them in practice and what their limitations are.
The Accounting Rate of Return Is Important to Understand
A quick and easy way to determine whether an investment is yielding the minimal return needed by the business is to use the accounting rate of return as a tool for investment appraisal. In contrast to the internal rate of return and net present value, ARR focuses on net income instead of cash flows.
Do you need assistance figuring out your accounting rate of return? We can help! Our goal is to provide you with an alternative way to handle your bookkeeping, financial reporting, and back-office tasks. Contact us or check out our Blog section for helpful information.