By FMTeam Do you even know what the Accounting Rate Of Return or ARR for short, is? Well, just to put it in the simplest words possible, it is a method to figure out how much profit you are making with a particular project or investment every single year. That’s all. And it is not that even complicated, just divide the profit numbers with the investment made, and the answer will be your ARR. Simple as that.
But the main question remains: Why do we even use the Accounting Rate Of Return in the first place? Like, what good is it, and when should you be avoiding it? Well, those are precisely the questions we will be answering today because this post is all about Accounting Rate of Return (ARR) Advantages and Disadvantages. So, if that’s what you are here for, just keep on reading.
Advantages of ARR
1. Super Simple and Easy to Calculate
Every business should know the numerous benefits of the Accounting Rate of Return (ARR) as it is one of the easiest and quickest ratios to not just understand but also calculate. Like, you don’t need to be knowledgeable in finance, a mathematics wizard, or anything like that to apply this method. Just so you know, this type of rate of return is actually based on primary accounting data that most businesses have at their disposal which makes it a good choice for newbies in the financial analysis field, and that’s what makes it special.
2. Uses Data You Already Have
The ARR works on profits that have been reported in financial statements, did you know that? And sure, this way, companies can easily calculate ARR with the data totally in line with the regular accounting they already have. With this, you have no reason to worry about analyzing cash flows or making adjustments for taxes and interest charges as this is the information collected through basic accounting practices.
3. Makes Comparing Projects a Breeze
It is a 100% true that it becomes really easy when organizations have to select from multiple projects. They can use the ARR method to do this with the greatest of ease. This is because it gives a straightforward percentage return for every project allowing decision-makers to have a quick glance at the most profitable one, you know? Like, for instance, if one project yields an ARR of 20% and the other gives an ARR of 15%, then, assuming the rest of the parameters are constant, the answer is the project with the 20% ARR.
4. Sets a Performance Bar
Just so you know, ARR doubles as an adaptable parameter to measure business performance. Like, to see how financially sound the business is, businesses can devise the business’ ARR and compare it to common industrial practices or internal benchmarks. Like, if a project’s ARR is under the predetermined level, it could indicate that the project is less profitable than it had been thought at first glance.
5. Takes the Long View
ARR gives a full-picture view of an investment’s profitability over time because it considers the entire life of the investment, but how’s that? Well, this is kinda different from some of the other metrics that are usually focused only on short-term growth, and this is where ARR stands by taking into account profits for the average lifespan of the investment.
6. Easy for Everyone to Understand
How’s that now? Well, we must say that ARR is a handy device for small investors or business operators who are not in charge of rigorous financial analysis. It gives a super easy-to-understand representation of how well their investments are reacting and caters to the needed instructions for their business investments and the decision to continue or just keep on going. Since ARR is based on simple profit data, it is an especially successful tool for those who want simple ways of decision-making, you know?
Disadvantages of ARR
1. Doesn’t Care About the Time Value of Money (TVM)
Just so you know why so many people don’t like it is that it does not consider the time value of money, which is a crucial concept in finance. Simply put, this means that ARR is treating money today equally as money received in the future, although money today is typically worth more than a future dollar because it can be invested to increase wealth, you know? That’s not it though, since ARR simply considers the average profit over time, the timing of projects does not matter.
2. Ignores When Cash Actually Flows In
In addition to that, the second drawback of ARR lies in the timing of cash flows that it just disregards. Like, since ARR is based on accounting profit, it includes non-cash items such as depreciation. Due to that ARR does not show the actual cash being available, you know? Just to give you an example of that, well, a project may show a great profit on the books but might not actually bring in cash until much later, making it hard for the company to cover immediate expenses.
3. Loves Short-Term Projects Too Much
As you might have noticed already, like, ARR tends to favor projects that show high profits in the short term, even if they may not be the best long-term option. Sure, this bias can lead businesses to prioritize short-term gains over more sustainable long-term investments, which may not be the best approach for long-term success. Like, an organization may invest in a project that brings in profits in the short term, even if this project ultimately fails or doesn’t pay off in the long run.
4. Arbitrary Cut-Off Points
Some businesses set a fixed ARR percentage that projects must meet to be approved, and this kind of strictness or cut-off point is often arbitrary and based on current performance or other factors, which can result in profitable projects being rejected.
Conclusion
That’s all there is for now. You see, at first glance, this ARR thing may sound way too easy at first, but when you get down to the details of it and use cases, you’ll realize how useful it can get in some cases. And since it is super simple to understand and calculate, that’s pretty much the reason why it is commonly used.