In a previous blog post, we discussed goodwill. Today, we’re going to explore another term that’s commonly used in financial accounting: rate of return. To learn more about rate of return and how/when it’s used, keep reading.
Also known as average rate of return or ARR, rate of return is a formula used in capital budgeting. It’s intended to calculate the expected return generated from the income of a capital investment. ARR is essentially a ratio that’s expressed as a percentage return. As explained by Investopedia, rate of return can be either a gain or loss on an investment, both of which are expressed as a percentage of the total cost of the investment.
Rate of return works by dividing the profit of the initial investment to acquire the expected return. It’s important to note, however, that it does consider factors such as the duration of the investment. As such, it may fluctuate over the life of the investment. If you have an investment with a 10% rate of return, it means the investment is expected to earn about $0.10 cents for every dollar annually. Generally speaking, the higher the rate of return, the better.
To calculate rate of return, you take the profit generated by the investment project and divide it by the initial cost of the project. This formula follows the Generally Accepted Accounting Principles (GAAP), which is one of the reasons why it’s preferred by accountants and small business owners. Calculating rate of return is also relatively easy and straightforward, which is another reason why it’s used.
However, there are also some downsides to using rate of return in account. For starters, this formula focuses on profits instead of cash flow — and it also ignores the cash flow from the respective investment project. As a result, rate of return may be affected by debt and depreciation.
Secondly, rate of return does not adjust for the risk associated with long-term forecasts. A long-term investment typically carries a higher risk than a short-term investment. Rate of return, however, does not take this into consideration, and instead uses the same formula for both types of investment.
Finally, rate of return may provide erroneous or otherwise misleading information about a company’s investment.
In any case, rate of return is a widely used, and acceptable, formula for calculating the expected profit generated from an investment project.
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