Why accounting rate of return matters to a first-time founder
Accounting rate of return (ARR) quickly compares an investment’s expected accounting profit with the money invested. Founders may use it for a first check of equipment or projects because it uses familiar profit figures. To make a fair comparison, use the same assumptions and say which investment amount you divide by.
Examples of accounting rate of return
A machine costs R1,000,000 and should produce average yearly accounting profit of R180,000 after depreciation, which spreads its cost over its useful life. Dividing by the original cost gives an ARR of 18%. Dividing by the average amount invested gives a different result, so state the formula before comparing projects.
Common misunderstanding
ARR is not a cash return. It does not properly account for when money arrives or the fact that money today is worth more than the same amount later. Some formulas use the original investment, while others use the average investment. Two ARR figures may therefore use the same name but not be comparable.
When to use it
Use ARR for a quick first check or explanation when projects use similar accounting assumptions. Define the profit figure, investment amount and time period. Then check cash flow separately, using a method such as net present value, which converts future cash into today’s value. Do not base an important investment decision on ARR alone.