Understanding Accounting Rate of Return (ARR): A Key Financial Performance Measure

by Knowledge Resources | 01/14/2023, 22:13

Accounting rate of return (ARR) is a financial performance measure that calculates the expected return on an investment based on the company’s net income and the initial investment required for the project. You express the accounting rate of return (ARR) as a percentage and use it commonly to evaluate the profitability of investments and to compare the relative performance of different investments.

Calculating the ARR

To calculate ARR, we divide the expected net income from the investment by the initial investment required and multiply by 100 to express the result as a percentage. The formula is as follows:

ARR = (Expected net income / Initial investment) x 100

For example, suppose that a company is considering a new project that requires an initial investment of $100,000. If the company expects the project to generate a net income of $20,000 per year, the ARR would be calculated as follows:

ARR = ($20,000 / $100,000) x 100 = 20%

This means that the company can expect to earn a return of 20% on its investment if the project is successful.

Limitations of ARR

It’s important to note that ARR is a simplified measure of return that does not take into account the time value of money or the length of the investment period. In fact, for example, a project with an ARR of 20% that takes 10 years to complete may not be as attractive as a project with an ARR of 15% that takes only 5 years to complete. Consequently, in this case, the second project would provide a higher annual return and would be a better choice from a financial perspective.

Conclusion

the accounting rate of return (ARR) is a financial performance measure that calculates the expected return on an investment based on the company’s net income and the initial investment required for the project. You use the accounting rate of return (ARR) to calculate the expected return on an investment based on the company’s net income and the initial investment required for the project. By expressing it as a percentage, it becomes easy to evaluate the profitability of investments and compare the relative performance of different investments. But remember, it is a simplified measure, so you should take into account other factors such as the time value of money while evaluating an investment’s profitability.