If you're making a long-term investment, it's critical to monitor your plans and budgets on a regular basis. The Accounting Rate of Return (ARR) is one of the most effective ways to measure the prospective profitability of an investment, making it a valuable tool for deciding which capital asset or long-term project to invest in. It is a great tool for making you a successful investor.
Helping to create successful investors
The Accounting Rate of Return (ARR) is the percentage return that may be expected from an investment or asset when compared to the original price of investment. ARR is frequently used in capital budgeting decisions because it allows you to evaluate whether continuing with a particular project, purchase, or another initiative is the right choice for your business's financial future.
The ARR formula is as follows:
- ARR = average annual profit / average investment
How to put this into practice:
How you can calculate ARR
- Identify the annual net profit associated with your investment (the revenue remaining after operating expenses, taxes, and interest associated with implementing the investment or project)
- If the investment is a fixed asset, such as property, identify the depreciation expense
- Subtract the depreciation expense from your annual revenue figure
- You then divide the annual net profit by the initial cost of the asset or investment
- The result of this will be a decimal, so multiply the result by 100 to see the percentage return
There are ARR calculators that you can use online to double-check your figures and help your investment success.
A business wishes to purchase new modes of transport for their employees. The purchase cost amounts to £350,000 and would increase the company’s annual revenue by £100,000, as well as the company’s annual expenses by £10,000. The modes of transport are estimated to have a useful shelf life of 20 years, with no salvage value. So, the ARR calculation is as follows:
- Average annual profit = £100,000 - £10,000 = £90,000
- Depreciation expense = £350,000 / 20 = £17,500
- True average annual profit = £90,000 - £17,500 = £72,500
- ARR = £72,500 / 350,000 = 0.2071 = 20.71%
The calculation shows that, for every pound that the company invests, it will receive a return of 20.71p. This is a good result and, considering external circumstances and other options, this may convince them to go ahead with the investment.
Use Excel to calculate ARR
You can use an Excel spreadsheet for ARR calculations. Simply follow the steps below:
- In A1, write ‘Year’.
- In C1-G1, write 1, 2, 3, 4, 5 (assuming a five-year project).
- In A2, write ‘Net Income’.
- In C2-G2, write the net annual income for each year.
- In A3, write ‘Initial Investment’.
- In B3, write the initial investment for the project.
- In A4, write ‘Salvage Value’.
- In B4, write the salvage value, if any.
- In A5, write ‘ARR’.
- In B5, write =AVERAGE(C2:G2)/AVERAGE(B3:B4).
- Press enter to calculate ARR.
- ARR will now show in B5.
These details may need to be adapted depending on the specifics of your project. For example, your project may last longer than five years. Being able to calculate ARR can give you an idea of how much money your potential investment is likely to generate and thereby increase your risk tolerance.