What does ARR (Accounting Rate of Return) mean?

by Adarsh Raj Bhatt in
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Key takeaways

  • The accounting rate of return (ARR) formula is useful for calculating a project's yearly percentage rate of return.
  • When evaluating numerous projects, you can use ARR to calculate the expected rate of return for each one.
  • ARR does not distinguish between investments that produce various cash flows over the project's lifetime.
  • When calculating the yearly percentage rate of return on a project, the accounting rate of return is a useful financial instrument. With that said, the calculation is not without flaws.
  • The accounting rate of return ignores the greater risk and uncertainty that long-term initiatives entail.
  • It provides you with a high-level overview of your startup’s health and assists you in calculating the rate at which you must grow to maintain your current level of success.

What is the Accounting Rate of Return?

The Accounting Rate of Return (ARR) is the projected percentage rate of return on an investment/asset contrasted with the initial investment price. 

ARR is commonly employed in corporate finance decisions. For instance, if your startup needs to choose whether or not to go ahead with a specific investment, whether it's a kind of venture or purchase, an ARR computation can help assess whether doing so would be the best course of action.

How does the Accounting Rate of Return work?

ARR gives you crucial information about the state of your startup. You may use this information to anticipate how profits will improve as your startup expands and then determine what you'll do next. ARR gives you a high-level look at your annual progress, which can be quite insightful for thinking about long-term product development and planning the roadmap of your startup. The high-level view afforded to you by ARR will let you see these two elements (product development and the startup roadmap) in a more integrated and interconnected light, which, in turn, will allow you to plan your roadmap more efficiently and track your progress more frequently (and accurately). This provides you with more insight and clarity to make optimum decisions, pivot faster, and provide a significantly better user/customer experience.

To monitor the stability of your startup over time, you'll need a thorough understanding of the startup's existing financial condition and how you're doing in terms of meeting yearly market expectations. Understanding the direct impact of your choices is critical whether you're (re)assessing product-market fit, planning future launches for updated functionality, or continuing to focus on expansion revenues (or the revenue growth that you derive from your existing customer base).

One of the finest methods for understanding both the startup’s current financial state and the impact of potential decisions is through ARR.

Benefits of Accounting Rate of Return (ARR)

#1: Simplicity of Use

Accounting rate of return (ARR) is a commonly used method of comparing capital projects. It takes into account the total gains/savings over the project's whole financial life. Because it is based on basic accounting data, no extra-specific reports are necessary to calculate ARR. The ARR approach is fairly straightforward - both to compute (or calculate) and to comprehend. This is why almost anyone can understand it. Calculating the ARR of various projects is quite simple (and so is the calculation of the payback period). 

Bottom line?

ARR (Accounting Rate of Return) has an incredible simplicity of use - which is one of the reasons why it’s so widely accepted across the startup landscape. 

#2: Gauge the Asset’s Profitability

The ARR approach is dependent on accounting profit and, hence, gauges the asset's profitability. 

The notion of net income (or earnings after taxes, deductions, and depreciation) is recognized by this approach. For computing the rate of return, this method alone uses the “accounting notion” of profit. Furthermore, the accounting profit may be estimated easily by using the accounting data. This is an important consideration while looking to evaluate an investment proposition.

#3: Making a Selection on a Good Capital Project

Making a selection on a good capital project is simple with ARR. 

This is because ARR is a useful tool for calculating a project's annual percentage rate of return. The project with the highest ARR is viewed in a positive light, while the project with the lowest ARR might be dismissed. When evaluating numerous projects, ARR can be employed because it calculates each project's expected rate of return. This strategy makes it easier to compare new product development initiatives to cost-cutting efforts or other competing projects.

#4: Serves the Interests of the Owners

As mentioned before, ARR is a metric that gauges a project's profitability - which is useful to both shareholders and owners. Any asset evaluation strategy that employs ARR has the advantage of being informed by a reliable overview of a project's profitability. A startup’s performance levels can also be assessed in a financial context by employing ARR. In this way, the evaluation strategy (that employs ARR, as opposed to one that doesn’t) serves the owners' interests, who are primarily concerned with the return on their investment. 

Limitations of Accounting Rate of Return

When using the accounting rate of return, keep the following points (or limitations) in mind:

#1: Centered on Probability

The ARR is different from other investment appraisal methodologies in that it is centered on profitability instead of cash flow. As a result, the calculation is impacted by qualitative and non-cash items (like the depreciation rate) that startups employ to compute profits.

#2: Ignoring Profit Timings

In addition, the ARR doesn't account for profit timings. A $100,000 gain 5 years from now is given the same value as a $100,000 profit this year when computing ARR. In truth, getting the revenue relatively sooner is not just preferable, but it also holds a different kind of value when one makes a practical comparison of the two scenarios.

#3: Inconsistency in Formulae

Another limitation of the ARR approach is that ARR can be calculated using a variety of different formulas. Therefore, if you're going to utilize the ARR to evaluate distinct investments, make sure you're computing it consistently.

#4: External Elements Unaccounted For

External elements that affect the project's revenue are not taken into account in the ARR strategy. Many startups' accounting rate of return does not stay unchanged over their useful lives. This means that when financing a project that will be developed in sections, the ARR strategy will not work optimally. At one moment, the financial performance of the project might appear to be adhering to the ARR, but at another, it might not appear to do so, all because of the distributed nature of the development of the project. As a result, a project may appear beneficial at one moment but not at another.

#5: Difficult Decision-Making

It's pointless to assess projects where money is invested in 2 or more installments on separate dates. When one estimates ROI and another calculates ARR, the findings are different. It makes decision-making difficult. The only way to tell how much money your startup makes is to track the entire yearly cash amount of subscriptions. You might get the most realistic picture of your startup's financial status and performance if you include just the actual income generated by the subscriptions.

How to Calculate the Accounting Rate of Return?

The most commonly used formula to calculate ARR is:

ARR = average annual profit / average investment

Where:

  • Average Annual Profit = Total profit over Investment Period / Number of Years
  • Average Investment = (Book Value at Year 1 + Book Value at End of Useful Life) / 2

A few key pointers:

  • If the ARR is 5%, the system is expected to raise five cents per dollar invested each year.
  • If the ARR is equal to or more than a startup's required rate of return, then the project is acceptable in terms of decision-making because the startup will earn at least the required rate of return.
  • The project probably might be rejected if the ARR is less than the required rate of return. As a result, the more the ARR, the more profitable the startup will be.

How to Find the Accounting Rate of Return?

Calculating the ARR is a straightforward process. To compute ARR, follow these steps:

  • To begin with, determine your asset's annual net profit. After operational expenditures, tax, and any interests involved in executing the investment/project have been subtracted, the annual net profit will be the leftover (or net) revenue.
  • Fixed assets, such as real estate depreciate. If the investment is a fixed asset, calculate the depreciation expense.
  • After this, remove the accumulated depreciation (calculated in the previous step) from your annual revenue amount to obtain the resultant figures for annual net profit.
  • Lastly, divide the annual net profit by the asset's/investment's original cost. Because the answer will be in decimals, multiply it by 100 to get the percentage return.
  • If you're unsure how to work it out on your own, you can use an ARR calculator online to double-check your calculations. While several ARR calculators are available to explore on the internet, EasyCalculation provides a straightforward tool for calculating your ARR.

Here's a case study on how to apply the Accounting Rate of Return formula. A startup wishes to purchase a new range of trucks for its operations. The vehicles would cost $350,000 and raise the startup's annual earnings by $100,000 while also increasing its annual expenses by $10,000. The vehicles are anticipated to have a 20-year usable life and no book value. 

In light of this data, the ARR would be calculated as follows:

  • Average annual profit = $100,000 - $10,000 = $90,000
  • Depreciation expense = $350,000 / 20 = $17,500
  • True average annual profit = $90,000 - $17,500 = $72,500
  • ARR = $72,500 / 350,000 = 0.2071 = 20.71%

In this case, the startup will earn a return of 20.71 cents for every dollar it invests. That's a decent ARR - and if it's superior to the alternatives that the startup is looking into, it might persuade the founders to proceed with the investment.

What is ARR used for?

Accounting Rate of Return (ARR), often referred to as the average rate of return, is a metric that calculates the projected profit from capital investments. ARR calculates the profit from investments using basic calculations, which aids in the evaluation of capital projects. To calculate the ARR, divide the net income from an investment by the total amount invested.

Investors are allowed to assess the reliability and sustainability of capital projects by using ARR. It also aids investors in assessing the risk associated with investments and determine if the investment will generate sufficient revenues to cover the risk level. ARR boasts usage among the most widespread in financial ratios, and it's useful for comparing and selecting projects during the decision-making process. However, because ARR does not account for interest, taxes, inflation, or other factors, it is insufficient for large, long-term capital expenditures.

In conclusion...

The accounting rate of return is a corporate finance indicator that may be used to quickly determine the profitability of a project. Startups use ARR to evaluate multiple projects/decisions, establish the expected return rate on each, and aid in the decision-making process for an investment/acquisition. Any yearly expenses related to the project, like depreciation, are factored into the ARR. Depreciation is a beneficial accounting provision that allows the value of a fixed asset to be stretched out or expensed throughout the item's useful life. This enables the startup to profit from the asset straight away, even if it is still in its first year of operation.

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Citations

  1. Accounting Rate of Return and How to Calculate
  2. Understanding Accounting Rate of Return (ARR)
  3. Accounting rate of return
  4. Accounting rate of return method
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