Accounting rate of return

From CEOpedia | Management online
Accounting rate of return
See also

The accounting rate of return (ARR) is a financial metric used to evaluate the profitability of an investment or project. It is calculated by dividing the average annual profit by the initial investment, and expressing the result as a percentage. The ARR is used to compare the profitability of different investments or projects, and to determine whether an investment or project is worth undertaking. However, it has some limitations and it's important to evaluate the investment or project using other financial metrics as well.

Accounting rate of return formula

he formula for the accounting rate of return (ARR) is:

ARR = (Average annual profit / Initial investment) x 100

Where:

  • Average annual profit is calculated by taking the average of the annual net income over the life of the investment or project.
  • Initial investment is the amount of money invested in the project or investment.

It is important to note that the ARR is a relative measure of profitability and it doesn't take into account the time value of money and other factors, it is generally recommended to use other financial metrics such as net present value (NPV) or internal rate of return (IRR) in order to evaluate the potential profitability of an investment or project.

Accounting rate of return in Excel and LibreOffice

The accounting rate of return (ARR) can be calculated in Excel and LibreOffice using the following steps:

  1. Input the initial investment amount in a cell, for example, cell A1.
  2. Input the net income data for each year in a range of cells, for example, cells A2 to A5.
  3. In a new cell, for example, cell B1, use the formula =AVERAGE(A2:A5)/A1 to calculate the average annual net income divided by the initial investment.
  4. Multiply the result from step 3 by 100 in cell B1 to express the result as a percentage using the formula =B1*100
  5. You now have the accounting rate of return in cell B1.

Here is an example of the formula: =(AVERAGE(A2:A5)/A1)*100

In LibreOffice, the steps are similar, the formulas are the same. However, the layout of the spreadsheet software may be different.

It's important to note that this is an example of how to calculate ARR in Excel and LibreOffice, and the specific formulas and layout may vary depending on the specific data and investment or project being evaluated.

ARR advantages

The accounting rate of return (ARR) has several advantages as a financial metric:

  • It is simple to calculate: The formula for ARR is straightforward and easy to understand, making it accessible to non-financial professionals.
  • It is easy to interpret: ARR is expressed as a percentage, which makes it easy to understand and compare the profitability of different investments or projects.
  • It is based on historical data: ARR is based on historical data, which makes it easy to calculate and can be used to compare the past performance of different investments or projects.
  • It can be used to compare different investments or projects: ARR can be used to compare the profitability of different investments or projects, which can help in decision making.
  • It is widely used and understood by many people: ARR is a widely used financial metric and is understood by many people in business, finance and accounting.

It is worth noting that while ARR is a useful metric, it should not be used in isolation as it doesn't consider the time value of money and other factors that are important to evaluate the profitability of an investment or project, it is recommended to use other financial metrics such as net present value (NPV) or internal rate of return (IRR) to have a more complete view of the potential profitability of an investment or project.

ARR limitations

The accounting rate of return (ARR) has several limitations as a financial metric, some of which include:

  • It does not take into account the time value of money: ARR does not consider the timing of cash flows, which can lead to a distorted view of profitability.
  • It does not consider the risk of the investment: ARR does not factor in the risk of an investment, which can lead to a misleading comparison of different investments or projects.
  • It is based on accounting income rather than cash flows: ARR is based on accounting income, which may not accurately reflect the cash flows generated by an investment or project.
  • It does not reflect the magnitude of the investment: ARR does not take into account the magnitude of the investment, which can lead to a distorted view of profitability.
  • It does not consider the reinvestment opportunities: ARR does not take into account the potential for reinvestment of profits, which can lead to a distorted view of profitability.

Because of these limitations, it's important to use other financial metrics such as net present value (NPV) or internal rate of return (IRR) to evaluate the potential profitability of an investment or project. These metrics take into account the time value of money and risk, and give a more accurate picture of the potential profitability of an investment or project.

References

  • Brief, R. P., & Lawson, R. A. (2014). The role of the accounting rate of return in financial statement analysis. In The Continuing Debate Over Depreciation, Capital and Income (pp. 235-250). Routledge.
  • Magni, C. A., & Peasnell, K. V. (2012). Economic profitability and the accounting rate of return. Available at SSRN 2027607.
  • Richard, P. (2014). The Role of the Accounting Rate of Return in Financial Statement Analysis. The Continuing Debate Over Depreciation, Capital and Income (RLE Accounting), 235.