The Accounting Rate of Return (ARR) is a financial ratio that denotes the average percentage of net income expected on an investment or project based on the average net income of the project and the average investment in the project.
As it is easy to calculate, the ARR is a commonly used financial ratio that is often compared to a company or investor’s required rate of return. Should the Accounting Rate of Return exceed the required rate of return, the project can be deemed viable for investment. However, should the Accounting Rate of Return be lower than the required rate of return, a project may be considered a poor investment choice and may be rejected. The ARR does not consider the time value of money, which can be an integral factor in regard to investment decisions and is often calculated along with a Net Present Value (NPV) calculation or other project valuation methods.
The Accounting Rate of Return is calculated by summing the net incomes of an investment over a number of periods and dividing the summed product by the number of periods. That average net income is then divided by the initial investment amount.
The average periodic cash flow is the expected or actual inflow of revenue at a given period for an investment, divided by the number of periods the project is expected to make payments. Periodic cash flows can be cashflows per month over the course or a year or cashflows over the entire life of an investment or project, minus expenses for each period. Periodic Cash Flows can be either positive or negative.
The Initial Project Investment Cost is the amount invested at time zero of a project or investment, inclusive of costs incurred by the project over its life. Initial costs can be the purchase amount for shares in a portfolio, or the start-up costs and potential sunk costs for undertaking or initiating a project. The Initial Project Investment Cost is a negative figure.
The rate of return calculated after dividing the average net income of cashflows by the initial investment cost.
As it is one of the easiest ratios to calculate, the Accounting Rate of Return is one of the more prominent evaluation methods in project and investment evaluation. In terms of decision making, if the ARR is equal to or greater than the required rate of return for an investor or business, the project can be shortlisted for investment. However, should the ARR fall short of matching the required rate of return, the project should potentially be abandoned.
Consider a project with an initial investment of $5,000 with periodic cashflow payments of $2000 in period 1, $3,000 in period 2, and $1,750 in period 3. The total income for this investment would be $6,750, and by dividing by the number of periods we can find the average net income of $2,250 for the project. The Initial Project Investment cost is $5,000. By dividing this average net income by the Initial Investment Cost, we can calculate an ARR of 0.45 or 45%.
ARR = ((2000+3000+1750)/3) / 5000 = 0.45 = 45%
If the required rate of return is 10% then the project would definitely be considered for investment as the ARR is significantly higher than the required rate of return.
The ARR is one of the easiest project evaluation ratios to calculate and is helpful in determining the average percentage rate of return for a project. However, it is important to note that the Accounting Rate or Return does not adjust cashflow rates to take into consideration the time value of money, such as interest and inflation.
The ARR is also limited in that it does not consider increased risk or uncertainty associated with projects with high longevity; i.e. long-life projects.
Another consideration is that, as the formula works only with an average income value, it does not take into consideration the timing of payments. For example, an average net income of $5,000 might seem appealing for a 5-year project, but not if the project does not make a cashflow payment until the end of the fifth and final year of $25,000.
Due to it being easily to calculate and understand, the Accounting Rate of Return is widely used for fast project evaluations in the business world. However, it is important to remember the limitations such as time value of money, timing of payments, and the life of the projects that the ARR does not account for. It is important to use other project evaluation methods in conjunction with the ARR, such as Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period (PP) evaluation methods.
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