The Accounting Rate of Return (ARR), a financial terminology, quantifies the anticipated average yearly return achievable from an investment, expressed as a percentage of the initial investment cost. It provides a concise way for comparing predicted returns from various investment ideas and assessing investment prospects.
History
Early in the 20th century, when the stock market sector emerged and there were numerous investment options.
The ARR was initially employed as a tool to examine investment opportunities. It was frequently used as a quick way to calculate predicted return on investment, and it is still popular today.
Why use ARR?
ARR is a clear-cut measure that gives a quick estimation of the anticipated return on an investment. Because it is simple to comprehend and use, both consumers and corporations favor it. The measure offers a planning for comparing various assets, making it beneficial when assessing investment options.
Formula
Calculation: The average net income after taxes is divided by the cost of the initial investment to arrive at the ARR formula.
The equation reads as follows:
ARR = (Average net income after taxes) / (Initial investment cost) * 100
Example
Calculation example: Suppose an investment proposal has an initial investment cost of $100,000 and is expected to generate an average net income after taxes of $10,000 per year for a five-year period.
For this investment would be calculated as follows:
ARR = ($10,000 * 5) / $100,000 * 100 = 50%
ARR calculator
Accounting Rate of Return Calculator
Advantages and Limitations of ARR
Advantages
The Accounting Rate of Return (ARR) offers several advantages as a financial metric for evaluating investment opportunities. Its simplicity and straightforward calculation make it accessible to a wide range of users, from individual investors to corporate decision-makers. The ARR allows for quick comparisons between different investment options, aiding in the decision-making process.
Limitations
However, it’s important to acknowledge its limitations. ARR focuses solely on accounting numbers, which may not provide a comprehensive view of an investment’s true potential. It doesn’t consider the time value of money or the investment’s cash flow over time, which are crucial factors in assessing its profitability.
Additionally, ARR doesn’t account for the risk associated with an investment, potentially leading to skewed evaluations. Therefore, while ARR can serve as a valuable initial screening tool, it’s recommended to supplement it with other financial metrics and a comprehensive risk analysis.
Sensitivity Analysis in ARR Assessment
Sensitivity analysis, a topic not previously explored, plays a significant role when using ARR for investment assessment. By conducting sensitivity analysis, investors can understand how changes in various factors, such as net income projections or initial investment costs, impact the calculated ARR. This helps in gauging the robustness of investment decisions and considering a range of potential outcomes.
Sensitivity analysis adds a layer of depth to ARR evaluations, offering insights into the investment’s resilience to different scenarios and potential risks. Incorporating sensitivity analysis into the ARR assessment process enhances decision-making by providing a more nuanced understanding of an investment’s performance under varying conditions.
What is a good ARR?
A “good” Accounting Rate of Return (ARR) is a relative term that depends on the particular investment as well as the objectives and risk tolerance of the investor. But generally speaking, an ARR that exceeds the benchmark rate of return for a specific market or industry is seen as a strong return.
An ARR of 15% or above may be regarded as an excellent return for that industry, for instance, if the average return on investments in a certain sector is 10%.
However, a low risk tolerance investor might view an ARR of 8% as a reasonable return, while a high risk tolerance investor might only view an ARR of 20% or greater as a good return.
So the definition of a “good” ARR will ultimately depend on a number of variables, including the investment’s level of risk, the investor’s objectives and risk tolerance, and the anticipated return on alternative investment alternatives. Before making a choice, it is crucial to carefully assess the investment and take into account all pertinent considerations.
Conclusion
The Accounting Rate of Return (ARR), which gives a straightforward assessment of the anticipated return on an investment, is a widely used financial statistic. It is a common option for both people and companies because it is simple to comprehend, use, and evaluate investment alternatives.
ARR should not be used as the only indicator of an investment’s prospective profitability; rather, it should be one of many financial criteria that are taken into account when analyzing investment prospects.