Definition
The Accounting Rate of Return (ARR) is a financial metric that expresses the profit of an organization before interest and taxation, usually for a year, as a percentage of the capital employed at the end of the period. Variants of this measure include using profit after interest and taxation, equity capital employed, and the average of opening and closing capital employed for the period. Although it can be used to forecast returns on investment projects, discounted cash flow measures are generally acknowledged to be superior for this purpose.
Historical Context
The concept of the Accounting Rate of Return has been used for many years as a straightforward method for evaluating the profitability of investments. It was more prevalent before the adoption of more sophisticated discounted cash flow techniques. Historically, ARR was popular due to its simplicity and the ease with which it can be calculated from financial statements.
Types/Categories
- Before Tax ARR: Calculated using profit before interest and taxation.
- After Tax ARR: Uses profit after interest and taxation.
- Equity Capital Employed: Uses equity capital at the end of the period.
- Average Capital Employed: Uses the average of opening and closing capital employed for the period.
Key Events
- Early Adoption: ARR has been a cornerstone of investment analysis since the early 20th century.
- Development of DCF Methods: With the advent of discounted cash flow (DCF) methods, the use of ARR has declined but remains a useful metric in certain contexts.
Detailed Explanations
Formula
The formula for ARR can vary depending on the specifics of the calculation, but a general version is:
Importance
- Simplicity: One of the simplest methods to evaluate investment projects.
- Quick Comparisons: Facilitates easy comparison between different projects.
- Non-Cash Considerations: Accounts for non-cash factors such as depreciation.
Applicability
- Short-term Decision Making: Suitable for projects with shorter time frames.
- Internal Performance Metrics: Useful as an internal measure of performance for departments or divisions.
Examples
Consider an initial investment of $100,000 in a project expected to generate an average annual profit of $15,000:
Considerations
- Non-Discounted Cash Flows: Unlike DCF methods, ARR does not discount future cash flows.
- Accounting Profits: Depends on accounting rules and conventions, which may vary.
Related Terms
- Return on Investment (ROI): Measures the gain or loss generated on an investment relative to the amount invested.
- Net Present Value (NPV): The difference between the present value of cash inflows and outflows over a period of time.
- Internal Rate of Return (IRR): The discount rate at which the net present value of all cash flows is zero.
Comparisons
- ARR vs. ROI: Both measure profitability but ARR uses accounting profits whereas ROI focuses on net gains.
- ARR vs. NPV: NPV considers the time value of money, while ARR does not.
- ARR vs. IRR: IRR also considers the time value of money and provides a rate of return, making it more sophisticated than ARR.
Interesting Facts
- Historical Use: ARR was heavily relied upon before the widespread use of computational tools that facilitated complex calculations like NPV and IRR.
Inspirational Stories
- Classic Corporations: Many established corporations that began in the early 20th century relied on ARR as a key metric for initial project evaluations and expansions.
Famous Quotes
“Investing is not about beating others at their game. It’s about controlling yourself at your own game.” — Benjamin Graham
Proverbs and Clichés
- “A penny saved is a penny earned.” — Highlights the importance of return metrics.
Expressions, Jargon, and Slang
- [“Bottom Line”](https://financedictionarypro.com/definitions/b/bottom-line/ ““Bottom Line””): Refers to net income, a key component of ARR calculations.
- [“Top Line”](https://financedictionarypro.com/definitions/t/top-line/ ““Top Line””): Revenue, which impacts the calculation of profits used in ARR.
FAQs
Why use ARR over NPV or IRR?
Is ARR still relevant in modern finance?
References
- Brealey, R.A., Myers, S.C., & Allen, F. (2020). Principles of Corporate Finance.
- Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset.
Summary
The Accounting Rate of Return (ARR) offers a straightforward method for evaluating the profitability of investments by calculating the profit as a percentage of the capital employed. While modern techniques like NPV and IRR have largely replaced ARR due to their consideration of the time value of money, ARR remains a useful tool for quick comparisons and short-term decision-making. Understanding its strengths and limitations is key for effective financial analysis and investment evaluation.
