The Accounting Rate of Return (ARR), also known as the Simple Rate of Return, is a financial metric used to assess the profitability and efficiency of an investment or project. It calculates the average annual return generated by an investment, expressed as a percentage of the initial investment cost. Unlike cash flow-based metrics such as the Internal Rate of Return (IRR) or Net Present Value (NPV), the ARR focuses on accounting profit rather than cash flow, making it a straightforward method for evaluating the potential profitability of investments.
To calculate the ARR, the average annual profit from the investment is divided by the initial investment cost or the average investment over the period. The average annual profit is typically derived from the difference between revenues and expenses, excluding any capital costs or depreciation. This approach allows businesses to estimate the percentage return they can expect to earn on an investment, providing a simple measure of its financial performance.
The ARR is particularly useful for making quick comparisons between multiple investment opportunities or projects, as it provides a clear, understandable metric that can be applied consistently. However, it has limitations, including its reliance on accounting profits, which can be affected by non-cash items like depreciation, and its disregard for the time value of money, which means that it does not account for the fact that money today is worth more than the same amount in the future due to its potential earning capacity.
Despite these limitations, the ARR remains a popular tool for preliminary investment appraisal, especially for businesses that prefer to base decisions on accounting profits. It is often used in conjunction with other financial metrics that consider cash flows and the time value of money for a more comprehensive analysis. The ARR can also be helpful for evaluating the performance of investments that have already been made, providing insights into their actual versus expected profitability.
In summary, the Accounting Rate of Return is a financial metric used to evaluate the profitability of investments based on accounting profits. While it offers simplicity and ease of use, its limitations mean that it should be used as part of a broader set of tools for investment appraisal. Its focus on accounting profits rather than cash flow makes it a useful, albeit basic, measure of investment efficiency.