The accounting rate of return, also known as average rate of return, or ARR, is a

financial ratio A financial ratio or accounting ratio states the relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall fin ...

used in

capital budgeting Capital budgeting in corporate finance, corporate planning and accounting is an area of capital management that concerns the planning process used to determine whether an organization's long term capital investments such as new machinery, repla ...

. The ratio does not take into account the concept of

time value of money The time value of money refers to the fact that there is normally a 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 time ...

. ARR calculates the

return Return may refer to: In business, economics, and finance * Return on investment (ROI), the financial gain after an expense. * Rate of return, the financial term for the profit or loss derived from an investment * Tax return, a blank document or t ...

, generated from

net income In business and Accountancy, accounting, net income (also total comprehensive income, net earnings, net profit, bottom line, sales profit, or credit sales) is an entity's income minus cost of goods sold, expenses, depreciation and Amortization (a ...

of the proposed capital

investment Investment is traditionally defined as the "commitment of resources into something expected to gain value over time". If an investment involves money, then it can be defined as a "commitment of money to receive more money later". From a broade ...

. 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

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 environ ...

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 refers to two aspects of the same concept: first, an actual reduction in the fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wears, and second, the allocation i ...

methods. The ARR can give misleading information when evaluating investments of different size.

Basic formulas

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Pitfalls

# This technique is based on profits rather than

cash flow Cash flow, in general, refers to payments made into or out of a business, project, or financial product. It can also refer more specifically to a real or virtual movement of money. *Cash flow, in its narrow sense, is a payment (in a currency), es ...

. It ignores cash flow from investment. Therefore, it can be affected by non-cash items such as

bad debt In finance, 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 ...

s and

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 Forecasting is the process of making predictions based on past and present data. Later these can be compared with what actually happens. For example, a company might estimate their revenue in the next year, then compare it against the actual resu ...

. # ARR doesn't take into account the

References

Financial ratios Capital budgeting Corporate development Management cybernetics {{accounting-stub

Basic formulas

Pitfalls

See also

References