If you don't consider yourself to be overly investment-savvy, you may feel a bit daunted by the term Average Rate of Return. (It even made our list of the most confusing accounting acronyms and abbreviations!) Let's clear away some of that confusion, and see how average rate of return impacts your financial decisions as a small business owner.
What Does Average Rate of Return Mean?
Average Rate of Return (ARR) is a way to measure how much your company stands to make from an investment over the course of a year. Put another way, it’s the amount of profit (also known as “return” in this case) you can expect to make annually on an investment. If you were a private investor, you would want to figure out how much money you were likely to make on an investment - whether it was stocks, bonds, or real estate - before putting your hard-earned funds into such a venture. Well, the same holds true for a business of any size that’s looking to invest profits and get a return on that investment.
If you want to get an idea of an investment’s profitability, calculating ARR is a good way to assess it, and the calculation is fairly simple, as you’ll see below.
Calculating Average Rate of Return
To find the average rate of return on an investment, you take the total cash inflow that was brought in by the investment in question over the time period you’re analyzing, and divide it by the number of years of the investment. Multiply that result by 100, and you’ve got an ARR expressed as a percentage.
What does that look like? Let’s say you run a manufacturing company, and you’ve decided you want to invest in a some new manufacturing equipment to increase your business’ productivity. The new equipment costs $500,000. After factoring in operating expenses and any applicable fees and taxes (ex: insurance), the use of this new equipment leads to earnings of $40,000 the first year, then $45,000 the second year, and finally $50,000 in year three.
To calculate ARR in this situation, first you need to find the total cash inflow over the time period in question: $40,000 + $45,000 + $50,000 gives us a grand total of $135,000.00 in earnings over three years. Dividing this total by the number of years (3) gives us an average annual return of $45,000. Now let’s divide this average by the initial investment amount: $45,000 / $500,000 = 0.09. Multiply that by 100, and we have an average rate of return of 9%.
Pros and Cons of ARR
As we saw above, the formula for finding the average rate of return on an investment is pretty straightforward. The upside of this handy little calculation is that it allows you as a business owner to get a feel for potential profits to be made from different projects or product lines, and easily make comparisons between various plans.
However, this simplicity does have its drawbacks: for example, one factor that is not considered when finding ARR is the time value of money. What does this mean? The earnings that you bring in during the earlier years of an investment are potentially worth more than earnings gleaned in later years, simply because the profits made at the beginning can then be reinvested to grow profits even more extensively over time. ARR doesn’t take this notion into account, nor does it consider cash flows, which are very important to the running of a business. Read up on the importance of cash flow.
We hope this primer on average rate of return helps get you started on thinking of your own business’ investment strategy. Remember: this post is not meant to be construed as financial or legal advice - always consult a professional!
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