Posted by Early Growth
August 25, 2021 | 5-minute read (858 words)
As an entrepreneur, calculating whether an investment is likely to pay off is essential to making plans for future growth. To manage prospective expansions, it’s important to understand the Accounting Rate of Return (ARR).
Learning how to calculate the ARR gives you a powerful predictive measure of how effective an investment can be. Here’s everything you need to know about ARR finance and how to implement it into your broader business plans.
What is the Accounting Rate of Return (ARR)?
The ARR meaning is a formula that reflects the expected percentage rate of return on an investment or asset.
Under the ARR definition, you are dividing an asset’s expected net profit by its initial investment. This formula can be calculated for potential investments or on existing assets to ascertain whether a business activity continues to be profitable.
However, it does not take into account cash flow or time value of money, which is why the accounting rate of return formula is only an indicator rather than a number to live by.
When Should You Use ARR?
Now that you know the answer to “What is ARR?” it’s important to know when to use it.
Its primary use is to compare multiple potential projects.
If a business has a limited budget and multiple investment options, leadership teams will work together to project the average rate of return on all proposals. The accounting rate of return will give them a strong indicator of which projects may be the most profitable for the business.
Another use for the accounting rate of return formula is to figure out whether a certain project has met its goals and expectations.
Many businesses will perform this calculation on different activities every 12 months to ensure their projects are still on track and whether changes need to be made.
This can be helpful for entrepreneurs who need to decide whether to provide additional, continual investment for a specific asset.
The ARR formula is as follows:
Average Rate of Return = Average Annual Profit / Average Investment
To work out the average investment figure, you need to add the book value at year one and the book value at the end of the asset’s or investment’s useful life. This figure is then divided by two to get the average investment figure.
Interpreting the final figure is simple. The percentage figure for the average accounting return will tell you if a project is profitable or not.
A final positive figure of 10% would indicate a project is expected to generate 10 cents in profit for every dollar sent. A negative percentage would indicate a project would lose money and should be rejected.
Determining Your Annual Profit
Determining annual profit is difficult in the context of this formula because nothing is absolute.
For example, businesses may only be estimating annual profits rather than basing it on real-world figures.
Furthermore, the timing of cash flows is not taken into account, which can give a false perception of how successful an investment might be. Thus, the time value of money is ignored.
The primary aspect that must be taken into account is the depreciation of an asset. Simply take the cost of the investment and divide it by the number of years the investment is expected to last.
The depreciation figure should be subtracted from the average annual profit to get the true average annual profit.
So how do you work out the accounting rate of return?
Step One – Work out the expected annual net profit from an investment. This is revenue minus expenses, which includes operating expenses and taxes.
Step Two – Work out the depreciation expense.
Step Three – Subtract the depreciation expense from the annual net profit to get the true average annual profit.
Step Four – Divide the true average annual profit by the initial investment of the project.
Step Five – This percentage figure tells you whether the project is likely to be profitable or not. A positive percentage means a profit, and a negative percentage means a loss.
To enhance your understanding of the accounting rate of return formula, look at the following example:.
Beaver Rental Cars
Beaver Rental Cars want to incorporate new vehicle models into its business. It calculates that for an investment of $400,000 it can increase annual revenue by $75,000. Its annual expenses would be $15,000, and the vehicles have an estimated shelf life of 20 years.
Here’s its calculation:
Average annual profit is $75,000 - $15,000 = $50,000
Depreciation is $400,000 / 20 =$20,000
True average annual profit is $50,000 - $20,000 = $30,000
Average rate of return is = $30,000 / $400,000 = 0.075 x 100 = 7.5%
In other words, this would be a profitable investment, whereby the company would earn 7.5 cents for every dollar invested. It’s not particularly high, so Beaver Rental Cars may want to look elsewhere.
The average accounting return is an incredibly useful accounting tool for determining whether to greenlight a project. If you need help with finance and accounting for startups, contact Early Growth.