What Is the Accounting Rate of Return?
The accounting rate of return (ARR) is an indicator of the performance or profitability of an investment. It is also known as ARR or accounting profit rate of return.
How to Calculate Accounting Rate of Return?
Accounting Rate of Return Formula; ARR = (Net Income / Average Investment) * 100%
Accounting Rate of Return is calculated by taking the beginning book value and ending book value and dividing it by the beginning book value. The Accounting Rate of Return is also sometimes referred to as the “Internal Rate of Return” (IRR).
Accounting Rate of Return Formula
For example, you invest 1,000 dollars for a big company and 20 days later you get 300 dollars as revenue.
- Initial investment: $1,000
- Expected revenue: $300
- Time frame: 20 days
- ARR calculation: $300 (revenue) / $1,000 (initial cost)
- ARR = 0.30 or 30% (0.30 * 100)
Why Use the Accounting Rate of Return?
The accounting rate of return is one of the most common tools used to determine an investment’s profitability. Accounting rates are used in tons of different locations, from analyzing investments to determining the profitability of different investments.
This is a solid tool for evaluating financial performance and it can be applied across multiple industries and businesses that take on projects with varying degrees of risk.
The following are the reasons why a company uses ARR.
- Useful when making comparisons between companies to measure how well one company is performing against another company.
- Used to show the book profit on an investment over time, which can be compared to returns from other investments or projects
- Useful in showing how well a project does when using funds within a certain period.
- Can help you see if your investment is profitable or not. Accounting Rate of Return can also help you prioritize your investments.
- Useful for companies that are looking to prioritize projects and investments based on profitability.
- Can give investors an idea of how well their investment is performing compared to other companies with similar assets, assets, equity, etc
- Can give investors an idea of how their investment is performing over time
- Can also help with determining what types of projects a company should invest in, and which ones it shouldn’t invest in
- Can show you whether a project’s return is good or bad
- Can show you what the return on investment is
- Can be used to measure how well a project does in terms of book profit
Limitations of Accounting Rate of Return
There are some limitations when using Accounting Rates of Return, which include:
- Smaller companies may not have a significant ARR because it is a number that represents the entire investment and any changes in the beginning book value can skew the Accounting Rate of Return
- When looking at larger investments, Accounting Rates of Return can be difficult to use because this calculation is based on an investment’s profitability and not just a small portion of it
- This formula does not take in any dividends or other sources of finance in regards to the initial cash outlay
- Can be difficult to work with if there are any cash flows associated with the initial investment because the Accounting Rate of Return will only take into account the profit made on the initial dollar amount
- Do not include future costs or savings which may result from an investment
- May not give you a true representation of the investment’s profitability
- Only take into account profitability, but not the overall value of the asset
- Only take cash in and cash out into account, but not how much it will cost to replace assets when they are broken down, which can skew Accounting Rates of Return
The Bottom Line
Accounting Rates of Return are one of the most common tools used to determine an investment’s profitability. It can be used in many industries and businesses, including non-profits and governmental agencies.
It offers a solid way of measuring financial performance for different projects and investments.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.