Accounting rate of return, commonly known as the average rate of return, can be defined as a financial ratio that is calculated from the net income generated from the proposed capital investment. It gives an estimate of profits earned from the income before rate of interest calculation and tax deductions. This ratio is primarily used in capital budgeting where a lot of planning is done to determine the profitability on the investments made in a project.
Formula for Calculating Accounting Rate of Return
ARR can be associated closely with simple concept of return on investments. All the investment inflows are summed up sans the investment costs incurred in earning the profits over the capital investments.
ARR = Average net income (inclusive of operating profits + Cash in flows) - Depreciation / Average investment on accrual basis
Depreciation = (Total property cost - Salvage value) / Life of the property
Operating profits are the total profits earned from the company operations before tax deductions and interest payments. One of the major examples is capital budgeting, where this tool is used to evaluate the net profit income. This tool basically helps in focusing more on the accountable income than the cash flows, i.e by comparing the profit generated from the capital investments with the initial costs incurred in making the investments.
Say for instance, you make an investment which is expected to make a turn over of $10,000 annually for next 5 years. Initial costs incurred in making the investments amounts to $20,000. So what is the total profit anticipated? It is the sum of the expected profits (operational) and the investments cost, which is $30,000. So what is the annual profit expected? It is $30,000/5 which is about $6000.
ARR = ($6000 / $20,000) x 100 = 30%
This percentage aids in determining as to whether the rate of return calculated is worthwhile or not. ARR is also known as accrual rate of return as the calculations are based on accruement and not on cash flow concept.
Pros and Cons
This investment appraisal method is simple to understand and easy to use. The average rate of return can be readily calculated from the accounting data (unlike the Net Present Value and Internal rate of return methods). The profitability of the investments can be assessed with ease, using this tool. This tool is extensively used by many accountants today as a performance measure.
With all pros stated, this tool also has some major flaws. The major shortcoming is ignoring cash flows while calculating profitability of investments. For people who are not much aware of what cash flow means, here you go:
Cash flow, as the name suggests, is flow of cash into or out of business transactions over a definite span of time. This parameter carries great importance when determining the rate of return flow for a project, business liquidity, evaluating quality of income generated by accrual accounting and assessing the risks involved in financial transactions of a developing project.
Since, cash flow concept is not considered as a part of this methodology, the profitability assessment may not be accurate. Also parameters like time value of money and arbitrary yardsticks defining current returns on assets, are not included in the calculation of ARR. Such flaws can actually hamper the business as growing companies which are earning high rates of returns on their existing assets may not find a need to invest more on profitable projects with positive net present value.
Once you have calculated the accounting rate of return, you will be aware of how much profitability can be anticipated for your business project. So now that you are aware of what ARR is all about and what are its pros and cons, you can easily judge whether this tool will be of help in your business ventures.