Accounting rate of return, also known as the Average rate of return, or ARR is a
financial ratio used in
capital budgeting
Capital budgeting in corporate finance is the planning process used to determine whether an organization's long term capital investments such as new machinery, replacement of machinery, new plants, new products, and research development projects ...
. The ratio does not take into account the concept of
time value of money
The time value of money is the widely accepted conjecture that there is greater benefit to receiving a sum of money now rather than an identical sum later. It may be seen as an implication of the later-developed concept of time preference.
The ...
. ARR calculates the
return, generated from
net income of the proposed capital
investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested (yearly). If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. More than half of large firms calculate ARR when appraising projects.
The key advantage of ARR is that it is easy to compute and understand. The main disadvantage of ARR is that it disregards the time factor in terms of
time value of money
The time value of money is the widely accepted conjecture that there is greater benefit to receiving a sum of money now rather than an identical sum later. It may be seen as an implication of the later-developed concept of time preference.
The ...
or
risks
In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environme ...
for long term investments. The ARR is built on evaluation of profits and it can be easily manipulated with changes in
depreciation
In accountancy, depreciation is a term that refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wear, and second, the ...
methods. The ARR can give misleading information when evaluating investments of different size.
Basic formulas
:
where:
:
:
:
Pitfalls
# This technique is based on profits rather than
cash flow. It ignores cash flow from investment. Therefore, it can be affected by non-cash items such as
bad debt
Bad debt, occasionally called uncollectible accounts expense, is a monetary amount owed to a creditor that is unlikely to be paid and for which the creditor is not willing to take action to collect for various reasons, often due to the debtor not ...
s and
depreciation
In accountancy, depreciation is a term that refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wear, and second, the ...
when calculating profits. The change of methods for depreciation can be manipulated and lead to higher profits.
# This technique does not adjust for the risk to long term forecasts.
# ARR doesn't take into account the
time value of money
The time value of money is the widely accepted conjecture that there is greater benefit to receiving a sum of money now rather than an identical sum later. It may be seen as an implication of the later-developed concept of time preference.
The ...
.
See also
*
Average accounting return
References
Financial ratios
Capital budgeting
Corporate development
{{Accounting-stub