A Useful Guide To Calculating The Accounting Rate Of Return (AROR)
Accounting Rate of Return (AROR) is a key metric used by businesses to measure the profitability of their investments. It is an important tool for financial decision-making and helps organisations understand the rate of return they can expect from any investment they make.
This guide will provide an overview of AROR and explain how to calculate it accurately. We will also discuss its advantages, limitations, and some useful tips to consider when calculating AROR.
With this comprehensive guide, you can make better investment decisions and maximise your returns.
What Is The Accounting Rate Of Return (ARR)?
Accounting rate of return (ARR) is an invaluable tool for businesses. It allows them to make informed decisions when considering costly investments such as the purchase of equipment, the acquisition of another company or any other sizable business investment.
Furthermore, it is a key metric used in capital budgeting decisions. It helps to determine the average net income an asset can generate by looking at the ratio of its average capital costs and net income, expressed as a percentage on an annual basis.
If an investment yields more than the benchmark return rate required by a business, it may be worth considering. Otherwise, the investment will not be considered if its accounting rate of return is too low.
How To Calculate The Accounting Rate Of Return (ARR)
- ARR can be calculated by dividing the average annual profit of an investment by its average annual cost. This calculation is expressed as a percentage, which gives investors an idea of how much they can expect to gain or lose from their investment. This annual net profit should include revenue minus any annual costs or expenses of starting the project or investment.
- To calculate your net profit from a fixed asset such as property, plant, and equipment (PP and E), subtract any depreciation expense from the annual revenue. This will give you an accurate picture of your annual net profit.
- To determine the return on investment, divide the annual net profit by the initial cost of the asset or investment and then multiply that result by 100. This will calculate a percentage return expressed as a whole number.
In summary, to get a more clear picture of the formula here is a simplified version:
ARR= Average Net Profit / Average Investment
Elements Of ARR
A project with an ARR of 5% means the expected return is five cents per year for every dollar invested. This lets investors quickly evaluate their potential returns and make informed investment decisions.
If the Average Rate of Return (ARR) is equal to or higher than the required rate of return, then the project will be approved. This is beneficial as it ensures that a company’s minimum expected rate of return can be met.
When the ARR is lower than the expected rate of return, it is best to step away from the project. Consequently, a bigger ARR leads to more profitable operations for a business.
Common Examples & Application Scenarios for ARR Calculations
The most common examples and application scenarios for ARR calculations include analysing stocks, bonds, mutual funds, real estate investments, and other types of financial instruments. Additionally, they can be used to evaluate different investment strategies or portfolio mixes.
Looking at these examples, let’s apply them to a scenario:
The decision to purchase a new machine comes with great financial gain. This $100,000 investment will add up to an extra $150,000 in net profit over the next 10 years, and even when it reaches its end of life, it will still have a residual or salvage value of $10,000.
Firstly, calculate the average annual profit:
- Initial investment= $100, 000
- Additional profits= $150, 000
- Time frame= 10 years
- Minus depreciation (purchase cost minus salvage value)= $90, 000
- Total profits after depreciation: $60, 000
- Average annual profit over 10 years= $6, 000
Secondly, calculate the average investment costs:
- Average investment ($100, 000 of the first year’s book value as well as the additional $10, 000 from last year’s book value) /2= $55, 000
- This is where you will now have to apply the ARR formula:
$6, 000 (annual profit) / $55, 000 (average investment)= 0.109
- The final answer for the ARR investment would therefore be 0.1909 x 100 (10.9%)
Pros And Cons Of The Accounting Rate Of Return (ARR)
ARR provides a simple way to compare returns from different investments, helping to identify the most profitable ones.
It can also provide valuable insights into how well management utilises its resources and whether or not certain projects are worth pursuing.
ARR is an invaluable tool when managers need to evaluate the return of a project quickly. It simplifies the process by eliminating the need to factor in time frames and payment schedules and instead focuses on its profitability or lack thereof.
This powerful tool allows businesses to make informed decisions that maximise their returns while minimising risk.
Accounting rate of return is a useful tool for analysing the profitability of investments, but it has drawbacks.
It can provide an inaccurate profitability assessment due to its simplistic approach and does not consider risks or other factors influencing the return on investment.
Additionally, it may not be able to accurately measure long-term returns on investments due to its short-term focus.
As it stands, the concept of ‘time value of money’ is not considered. This theory states that money available right now has more worth than an identical amount in the future due to its potential earning potential.
Lastly, ARR also does not account for cash flow timing.
In conclusion, the accounting rate of return (ARR) is a financial metric used to measure the profitability of an investment. It is calculated by dividing the expected net income from an investment by the initial cost of the investment. ARR provides investors with important information about how much they can expect to earn from their investments.
By considering both short-term and long-term costs and benefits, ARR can help investors make informed investment decisions.
Ultimately, ARR helps investors decide whether or not an investment is worth making based on its potential returns. Therefore, every successful business should invest in this golden tool!
What is the difference between the Accounting Rate of Return vs the Required Rate of Return?
ARR and IRR stand apart in their approaches, where IRR is a discounted cash flow formula while ARR uses a non-discounted cash flow formula.
The latter doesn’t consider the present value of future cash flows generated from an asset or project. Unlike IRR, ARR does not consider the time value of money.
Are there any decision rules for the Accounting Rate of Return?
Does depreciation impact the Accounting Rate Of Return?
Yes, it does.
Depreciation can impact the accounting rate of return by decreasing its value. It is a direct expense and will cut down a company’s asset price or profits. Consequently, it lowers the return on investment like any other cost.