The Accounting Rate of Return (ARR), also known as the Average Rate of Return or the Simple Rate of Return, is a financial metric used to evaluate the profitability of an investment. It provides an easy way to understand the percentage return an investor can expect from their investment over time. This article will discuss the process of calculating ARR, its advantages and drawbacks, and how it can be used in making informed financial decisions.

Step 1: Understand the Formula

The ARR is calculated using the following formula:

ARR = (Average Annual Accounting Profit / Initial Investment) x 100

This formula takes into account the average profit generated by an investment during its lifespan and compares it with the initial investment.

Step 2: Gather Relevant Information

Before calculating ARR, you will need the following data:

– The initial investment cost

– The estimated life of the investment

– The residual value, if any, at the end of the investment period

– The annual accounting profits generated by the investment for each year

Step 3: Calculate Average Annual Accounting Profit

To calculate the average annual accounting profit, first determine each year’s profit. Then add up all these profits and divide by the number of years in which profits were generated. This will give you an overall average profit per year during the investment period.

Step 4: Apply ARR Formula

With all relevant information in hand, apply the ARR formula mentioned earlier to calculate the Accounting Rate of Return. Take note that if there’s residual value at the end of an asset’s lifespan, subtract it from your initial investment before applying this formula.

Pros and Cons of Using ARR

There are a few benefits and drawbacks to consider when using ARR as a financial metric:

Pros:

1. Simplicity: The main advantage of using ARR is its simplicity. It’s easy to understand and calculate.

2. Comparing investments: ARR can help compare different investment opportunities and make decisions on their relative profitability.

Cons:

1. Ignores time value of money: ARR doesn’t take into account the time value of money, which can be a major drawback for long-term investments.

2. Based on accounting profits: The ARR calculation is based on accounting profits, which can be subject to manipulation or adjustments for non-cash items such as depreciation.

In conclusion, the Accounting Rate of Return is a simple metric that can help investors evaluate the profitability of an investment. Though it has its drawbacks, ARR remains a popular and widely used tool for comparing investment opportunities. By understanding how to calculate ARR and considering its pros and cons, investors can make more informed financial decisions.