The Accounting Rate of Return (ARR) is a financial metric used to evaluate the profitability of an investment. It measures the expected annual accounting profit from an investment as a percentage of the initial or average investment cost. The formula is:
ARR = (Average Annual Accounting Profit / Initial Investment) × 100
ARR focuses on net income, not cash flow, and is based on accounting information from financial statements. It provides a straightforward way to compare the expected returns of different investment projects or assets.
One key advantage of ARR is its simplicity. It helps businesses quickly assess whether a project meets a minimum return requirement. However, because it uses accounting profit rather than cash flow, it doesn’t account for the time value of money or actual cash inflows, which are critical in long-term investment decisions.
For instance, if a company is considering buying a new machine, it will calculate the ARR by dividing the machine’s average expected annual profit by the cost of the machine. If the result exceeds the company’s required rate of return, the investment may be approved.
Despite its limitations, ARR remains a useful tool for initial screening of potential investments.
