Oops! Something went wrong while submitting the form.
Get a Demo
See your data in HubiFi < 2 days
See practical examples of ARR to help you compare investments and make confident financial decisions. Learn how to use these examples of ARR in your strategy.
Deciding where to invest your company’s capital can feel overwhelming. With so many potential projects and purchases vying for a limited budget, how do you make an objective choice? You need a simple tool to compare your options on an even playing field. The Accounting Rate of Return (ARR) is that tool. It cuts through the complexity to give you a single, easy-to-understand percentage that reflects an investment's potential profitability. It’s the perfect first step in your financial analysis. In this guide, we’ll break down how to calculate it and provide several clear examples of arr so you can see exactly how it works in real-world business scenarios.
When you’re weighing a potential investment, whether it’s new machinery or a major software overhaul, you need a straightforward way to gauge its profitability. That’s where the Accounting Rate of Return (ARR) comes in. It’s a simple metric that helps you understand the potential return from an investment based on its expected profits. Think of it as a quick financial health check for a project, giving you a clear percentage to help guide your decision-making process.
Unlike some more complex financial metrics, ARR is relatively easy to calculate and understand, making it a go-to tool for initial screenings of investment opportunities. It helps you compare different projects on an apples-to-apples basis to see which one offers the most bang for your buck. By focusing on accounting profits, it aligns directly with the numbers you see on your financial statements, making it an intuitive part of your overall financial analysis.
At its core, the Accounting Rate of Return measures the average annual profit an investment is expected to generate, expressed as a percentage of its average cost. If you’re looking at a project and want to know, "On average, what yearly return can I expect from this?" ARR gives you that answer. It’s a valuable performance benchmark that allows you to evaluate an investment’s potential against your company’s internal targets or industry standards. This matters because it provides a clear, consistent way to vet opportunities before you commit significant capital. For instance, if your company has a rule to only pursue projects with an ARR of 15% or higher, you can quickly filter out options that don’t meet the criteria. It’s a practical first step in the capital budgeting process that brings clarity to your investment strategy.
The formula for ARR is straightforward: Average Annual Profit divided by the Average Investment. Let's quickly break down those two parts. The Average Annual Profit is the total net income you expect the investment to produce over its entire lifespan, divided by the number of years it will be in use. This gives you a clear picture of the profit you can anticipate each year. The other piece, Average Investment, is the average book value of the asset over its life. You can typically find this by adding the initial cost of the investment to its final or salvage value and dividing by two. By using the average investment, the formula accounts for the fact that the asset's value depreciates over time. Getting these two components right is the key to an accurate calculation.
While ARR is a useful tool, it’s important to understand its limitations. A common mistake is assuming a high ARR guarantees high future returns. In reality, ARR is based on historical or projected accounting profits, not actual cash flows, and shouldn't be the only factor in your decision. It’s a great starting point, but it doesn’t tell the whole story. The biggest drawback is that ARR ignores the time value of money. It treats a dollar earned five years from now the same as a dollar earned today, which we know isn't accurate. This can sometimes lead to a skewed view of a project's true profitability, especially for long-term investments. For a more complete picture, you’ll want to use ARR alongside other metrics that do account for the time value of money, like Net Present Value (NPV) or Internal Rate of Return (IRR).
Ready to figure out the Accounting Rate of Return for a potential investment? The good news is that you don’t need a complicated spreadsheet or a degree in finance to do it. The calculation is pretty straightforward, focusing on the potential profit an investment will generate compared to its cost. It’s a fantastic tool for getting a quick read on whether a project or purchase is worth pursuing.
The whole process boils down to one simple formula, which we’ll break down piece by piece. We’ll walk through how to find your average annual profit and the average cost of your investment. Getting these two numbers right is the key to an accurate ARR. Think of it as a quick health check for your investment ideas, helping you compare different options on an even playing field. For more tips on managing your company's finances, you can find great insights on the HubiFi blog. Let’s get started.
At its core, the ARR formula is simple:
ARR = Average Annual Profit / Average Investment
Let's look at what each part means. The Average Annual Profit is the average amount of net income you expect the investment to bring in each year over its useful life. The Average Investment is the average value of the asset over that same period. When you divide the profit by the investment, you get a percentage. This percentage tells you the annual return you can expect from the investment. For example, an ARR of 20% means the investment is expected to return 20% of its cost in profit each year. This makes it incredibly easy to compare different projects and decide which one offers the best bang for your buck.
Calculating the average investment is a two-step process. First, you need to know the initial cost of the asset and its salvage value. The salvage value is what you estimate the asset will be worth at the end of its useful life. Once you have those two figures, the formula is:
(Initial Cost + Salvage Value) / 2
For instance, let's say you’re buying a new piece of equipment for $50,000. You expect to use it for five years, and at the end of that time, you think you can sell it for $10,000. Your average investment would be ($50,000 + $10,000) / 2 = $30,000. This number gives you a more accurate picture of the investment's value over its entire lifespan, rather than just looking at the initial price tag.
To find the average annual profit, you'll need to estimate the total net income the investment will generate over its lifetime and then divide it by that lifespan in years. Remember, this is net profit, so you need to subtract all related expenses from the revenue the investment brings in. These expenses include things like operating costs, maintenance, and, importantly, depreciation.
This step requires a bit of forecasting. You’ll need to project the additional revenue the investment will create and the costs associated with it. Getting these projections as accurate as possible is key to a meaningful ARR calculation. It’s all about understanding the full financial impact the investment will have on your business operations each year.
Depreciation is the way an asset’s value decreases over time. Think about how a new car loses value the moment you drive it off the lot—that's depreciation in action. In accounting, depreciation is treated as an annual non-cash expense. Because it’s an expense, it reduces your annual profit.
When you calculate the average annual profit for your ARR, you must subtract the annual depreciation amount. An investment with a high rate of depreciation will show a lower annual profit, which in turn leads to a lower ARR. Accurately calculating depreciation is essential because it ensures your profit figure is realistic and reflects the true cost of owning the asset over time. Ignoring it can make an investment seem more profitable than it actually is.
Theory is great, but seeing how ARR works in the real world is where it really clicks. Let's walk through a few common scenarios where this metric can help you make a clear-eyed decision about where to put your money.
Imagine your manufacturing business is considering buying a new machine to increase production. The machine costs $100,000 and is expected to generate an average annual profit of $20,000 over its lifespan after accounting for operating costs and depreciation. To find the ARR, you divide the average annual profit ($20,000) by the initial investment ($100,000), which gives you an ARR of 20%. This simple percentage tells you that for every dollar invested in the machine, you can expect a 20-cent return each year. This figure gives you a solid basis for understanding the accounting rate of return and comparing this purchase against other potential investments.
Let's say your company has enough budget to pursue one major project this year. You could either launch a new marketing campaign or develop a new product feature. How do you choose? ARR can serve as a helpful tie-breaker. You would first estimate the average annual profit each project is likely to generate and the initial investment required for each. If the marketing campaign has an ARR of 15% and the new feature has an ARR of 22%, the choice becomes clearer. By comparing each project's ARR to your company's minimum acceptable rate of return, you can use it as a crucial performance benchmark to decide which initiatives get the green light.
ARR is also incredibly useful for personal investments, like buying a rental property. Suppose you're looking at a condo that costs $250,000. After factoring in your down payment, closing costs, and initial repairs, your total investment is $60,000. You estimate that after mortgage payments, taxes, insurance, and maintenance, the property will generate an average annual profit of $7,200. Your ARR would be $7,200 divided by $60,000, which equals 12%. This tells you if the investment is likely to meet your financial goals. For real estate investors, ARR is a valuable tool for assessing whether a property will yield sufficient returns relative to its upfront and ongoing costs.
Deciding whether to invest in new software or systems is a common challenge for growing businesses. Let's say you're considering implementing a new automated accounting platform to streamline your financial operations. The total investment, including subscription fees and implementation, is $50,000. You calculate that the new system will save your team 20 hours per week, reduce costly errors, and provide data that leads to better business decisions, resulting in an estimated average annual profit increase of $15,000. The ARR for this technology would be 30% ($15,000 / $50,000). This calculation helps you assess the financial viability of new technology and build a strong business case for adopting tools that drive efficiency.
Annual Recurring Revenue isn't just for software companies. While it found its fame in the tech world, ARR is a powerful metric that businesses across various sectors can use to measure financial health and predictability. Seeing how different industries apply this metric can give you fresh ideas for your own financial planning. From manufacturing floors to high-rise apartment buildings, the principle of tracking predictable, recurring income offers a clearer view of long-term stability.
You might not think of a factory when you hear "recurring revenue," but many manufacturers have found clever ways to use ARR. The key is to look beyond the one-time sale of a large piece of equipment. Many of these companies offer ongoing maintenance contracts, support packages, or subscription-based software upgrades for their machinery. By calculating the ARR from these service agreements, they can forecast revenue with much greater accuracy. This predictable income stream allows them to make smarter, more confident investment decisions about future growth and operational improvements, turning a traditional business model into a more stable one.
For real estate companies, ARR is a straightforward way to assess the health of their portfolios. Think of a property management firm or a developer with multiple rental units. Each lease agreement represents a source of recurring revenue. By adding up the annual income generated from all their leases, they can calculate a reliable ARR. This figure is crucial for understanding monthly and yearly cash flow, which in turn informs strategic decisions about acquiring new properties or starting new development projects. A strong, predictable ARR also makes it much easier to secure financing from lenders, who love to see stable, long-term income.
Utility companies are a classic, non-tech example of an ARR-driven business model. Whether it's for electricity, water, or gas, customers typically pay a recurring monthly fee for these essential services. This creates an incredibly stable and predictable revenue stream that is perfect for ARR calculation. For these companies, tracking ARR is fundamental to gauging their financial stability and planning for the future. When you need to make massive, long-term investments in infrastructure—like building a new power plant or upgrading a water treatment facility—having a clear picture of your annual recurring revenue is essential for ensuring you can meet customer demand while staying profitable.
The technology sector, especially the Software-as-a-Service (SaaS) world, is where ARR truly shines. For these businesses, ARR is more than just a metric; it's a primary indicator of growth and overall financial health. Since their entire model is built on customers paying for software access on a recurring basis, ARR perfectly captures their core business performance. A strong ARR signals a stable customer base and a reliable income stream, which is exactly what makes a business an attractive investment. For SaaS companies, a steadily growing ARR is the ultimate proof that their product is valuable and their business is on the right track.
Calculating the Accounting Rate of Return is just the first step. To truly make it work for your business, you need to use it as a tool for strategic decision-making. Think of ARR not as a final grade on an investment, but as a guide that helps you ask the right questions and compare your options clearly. It’s a straightforward metric, which is its biggest strength, but relying on it in a vacuum can be misleading. The real value comes from how you interpret and apply the result within a broader financial framework.
Using ARR effectively means putting the number into context. This involves setting internal goals, understanding its limitations, tracking performance over time, and seeing how you stack up against your industry peers. For example, a 20% ARR might seem great, but if your competitors are consistently hitting 30%, you might need to re-evaluate your strategy. Or, if an investment has a high ARR but also carries significant risk, you need to weigh that trade-off carefully. By combining these practices, ARR becomes a much more powerful part of your financial toolkit. It helps you allocate capital wisely, justify decisions to stakeholders, and ultimately drive sustainable growth for your company. Let's walk through how to do that.
Before you can decide if an investment is worthwhile, you need to know what "good" looks like for your business. A 15% ARR might be fantastic for one company but fall short for another. That’s why setting clear benchmarks is so important. Use ARR as a performance measure to evaluate an investment’s profitability against your own predetermined targets. These targets should align with your company’s financial goals and risk tolerance. You can also look at industry benchmarks to get a sense of typical returns in your sector, which helps you stay competitive and realistic about your expectations.
ARR is incredibly useful for its simplicity, but it has one major blind spot: it doesn’t account for the time value of money. In simple terms, it treats a dollar earned five years from now as equal to a dollar earned today, which we know isn't the case. This can give you an incomplete picture of an investment's true potential and risk. To get a more well-rounded view, you should pair ARR with other financial metrics like Net Present Value (NPV) or Internal Rate of Return (IRR), which do factor in the timing of cash flows. This approach gives you a more robust framework for making sound investment decisions.
An investment decision isn’t a one-time event. Once you’ve committed to a project or asset, you need to monitor its performance to ensure it’s meeting the expectations you set. Make it a habit to recalculate the ARR periodically using actual profit figures. This allows you to compare real-world results against your initial projections. Regular reviews help you spot issues early, make necessary adjustments, and learn from both your successes and failures. Automating your data collection through seamless integrations can make this process much smoother, giving you real-time insights without the manual effort.
Context is everything. An ARR that looks great on paper might be average—or even below average—for your specific industry. Capital-intensive industries like manufacturing might have different ARR expectations than a fast-moving tech company. Businesses often use ARR to ensure their investments are competitive and align with industry standards. Take some time to research what typical returns look like for your sector. This external perspective helps you set more realistic benchmarks and provides a valuable layer of validation when you’re evaluating different investment opportunities. You can find more on this topic in our HubiFi Blog.
While ARR is a fantastic tool for a quick profitability check, it’s not the only metric you should have in your financial toolkit. Think of it like this: you wouldn’t use just a hammer to build a house. You need different tools for different jobs. The same goes for financial analysis. Understanding how ARR stacks up against other common metrics like Net Present Value (NPV), Internal Rate of Return (IRR), and the Payback Period will help you see the full picture and make more informed decisions. Each one tells a slightly different story about an investment's potential, and knowing which one to use—and when—is what separates a good decision from a great one. Let's break down the key differences so you can feel confident choosing the right metric for any situation.
The biggest difference between ARR and Net Present Value (NPV) comes down to one crucial concept: the time value of money. In simple terms, a dollar today is worth more than a dollar a year from now because of inflation and its potential to earn interest. ARR averages out profits over an investment's life and doesn't account for this.
NPV, on the other hand, is built entirely around this idea. It calculates the current value of all future cash flows an investment is expected to generate. By doing this, NPV gives you a much more accurate assessment of an investment's true profitability over its entire lifespan.
At first glance, ARR and Internal Rate of Return (IRR) seem similar because they both give you a percentage return. But just like with NPV, the key difference is the time value of money. IRR is a more complex calculation that finds the specific discount rate at which the Net Present Value of a project’s cash flows equals zero. Essentially, it tells you the projected annual rate of growth an investment is expected to generate.
Because IRR incorporates the timing of cash flows, it provides a more dynamic and comprehensive view of an investment’s potential compared to ARR’s simple average. While ARR is great for a quick snapshot, IRR offers deeper insight into how efficiently an investment is working for you over time.
If ARR is about profitability, the Payback Period is all about speed. This metric answers one simple question: How long will it take to get my initial investment back? It’s focused entirely on liquidity and how quickly you can recoup your cash. This makes it a useful tool for assessing risk, especially if cash flow is a major concern for your business.
The downside is that the Payback Period completely ignores any profits earned after the initial investment is paid back. An investment might have a quick payback but low overall profitability. ARR, in contrast, looks at the average profitability over the asset's entire life, giving you a better sense of its long-term value.
So, how do you decide which metric to use? It all depends on your goals. If you need a quick, straightforward way to compare the profitability of several similar projects, ARR is a great place to start. But if you're looking at a long-term investment where the timing of cash flows is important, NPV and IRR will give you a more accurate and reliable picture. If your primary concern is minimizing risk and getting your money back quickly, the Payback Period is your go-to.
Ultimately, these metrics aren't mutually exclusive. The smartest approach is to use them together to get a well-rounded view of any potential investment. For more tips on strengthening your financial operations, check out the other articles on the HubiFi blog.
Calculating the ARR is just the first step. The real value comes from using that number to make smarter, more confident investment decisions. It’s a powerful tool for clarifying your options and ensuring your capital is working as hard as you are. Here’s how to put ARR to work for your business strategy.
Before you even look at a potential investment, you need a benchmark. This is your minimum acceptable rate of return—the absolute lowest return you’re willing to accept for a project to be considered. Think of it as your financial non-negotiable. If a project’s ARR falls below this number, it’s an easy "no," saving you time and resources. This rate isn't just pulled out of thin air; it's often based on your company's cost of capital or other internal financial goals. By setting this threshold, you create a clear, consistent filter for every opportunity that comes your way, ensuring that only the most promising investments make it to the next stage of consideration.
This is where ARR really shines. Let’s say you have three potential projects on the table: upgrading your software, buying a new piece of machinery, or expanding your office space. Each one has different costs and expected profits. How do you choose? ARR gives you a single percentage for each option, allowing for a straightforward, apples-to-apples comparison. This helps you move beyond gut feelings and use a consistent performance benchmark to evaluate profitability. By lining up the ARRs for each project, you can quickly see which one offers the most attractive return, helping you prioritize your investments and allocate your budget with confidence.
While ARR is a fantastic tool for financial analysis, it doesn’t operate in a vacuum. A high ARR is great, but the investment also needs to align with your company’s long-term vision. For example, a project with a slightly lower ARR might be the better strategic choice if it opens up a new market, enhances your brand reputation, or gives you a competitive edge. Use ARR as a key data point in your decision-making process, not the only one. Combine it with qualitative factors and your overall business goals to make well-rounded choices. For more on building a data-informed financial plan, check out the insights on our blog.
Like any financial metric, the Accounting Rate of Return has its moments to shine and its limitations. It’s a fantastic tool for getting a quick read on an investment, but it doesn't tell the whole story. Understanding both its strengths and weaknesses is key to using it effectively and making sure you’re not overlooking critical details in your financial strategy. Think of it as one important instrument on your dashboard—valuable, but best used in conjunction with others to get a complete picture of the road ahead.
When you’re weighing your options, it helps to have a clear view of what ARR can and can’t do for you. Let’s break down the main advantages and disadvantages you should keep in mind.
One of the biggest draws of ARR is its simplicity. You don’t need a complex spreadsheet or advanced financial knowledge to calculate it. This makes it an incredibly accessible metric for quick, initial assessments. It gives you a straightforward percentage that represents the potential return on an investment, which is perfect for high-level discussions and early-stage planning.
This simplicity is a huge asset when you're trying to forecast future profits. By providing a clear estimate of an investment's profitability, ARR helps you decide if a project is even worth a deeper look. It’s a great first-pass filter that helps you and your team focus your energy on the most promising opportunities, which is a core part of building a solid financial strategy.
When you have multiple projects competing for a limited budget, you need a way to compare them on an even playing field. ARR provides a clear benchmark for this. You can establish a minimum acceptable rate of return for your company, and any project that falls below that threshold can be quickly set aside.
This turns a potentially complicated decision into a more black-and-white one. For example, if your company’s minimum ARR is 15%, you can easily evaluate a list of potential investments and see which ones meet the criteria. This method serves as a performance benchmark, helping you evaluate the profitability of different options against your own targets. It streamlines the decision-making process, allowing you to move forward with confidence. If you want to see how better data can refine these benchmarks, you can always schedule a demo to explore more advanced analytics.
Here’s where we get into one of ARR’s most significant drawbacks. The metric doesn’t account for the time value of money, which is the principle that a dollar you have today is worth more than a dollar you might receive in the future. This is because today's dollar can be invested and earn interest.
ARR treats profits earned in the first year the same as profits earned in the fifth year, which can skew your perception of an investment's true value. A project that delivers returns faster is generally more valuable than one that delivers the same total return over a longer period. Because ARR averages profits over the investment's entire lifespan, it can sometimes make slower, less attractive investments appear just as good as faster ones.
ARR focuses exclusively on the numbers—average profit and initial investment—without considering the risks involved. It doesn't factor in external variables like market volatility, inflation, or the potential for a project to fail. This can be a major blind spot, as risk is a critical component of any investment decision.
An investment might have a high projected ARR, but if it’s in a highly unstable market or relies on unproven technology, it might not be the best choice. The metric doesn't capture the opportunity cost of tying up your capital in a risky venture when a safer, albeit lower-return, option is available. This is why it's so important to pair ARR with a thorough risk assessment and use comprehensive data to inform your final decision. At HubiFi, we believe that deeper data visibility is the key to making smarter, more strategic choices.
What's considered a "good" Accounting Rate of Return? There isn't a universal number that defines a "good" ARR. It really depends on your company and your industry. The best first step is to establish your own internal benchmark, which is the minimum return you're willing to accept based on your financial goals and the cost of capital. It's also smart to research the typical ARR for your specific industry, as a great return in manufacturing might look very different from a great return in tech.
Why can't I just rely on ARR for all my investment decisions? While ARR is incredibly useful for a quick profitability check, it shouldn't be the only tool you use. Its biggest blind spot is that it ignores the time value of money, meaning it treats a dollar earned years from now as equal to a dollar earned today. It also doesn't account for risk. An investment might have a high ARR but be extremely risky. For a more complete picture, you should use ARR alongside other metrics like Net Present Value (NPV) or Internal Rate of Return (IRR).
What's the most common mistake people make when calculating ARR? The most frequent error is forgetting to subtract annual depreciation from the annual profit. Depreciation is a real expense that reflects the wear and tear on an asset over time, and it directly impacts your net profit. Forgetting to include it will make an investment seem more profitable than it actually is, leading to an inflated and misleading ARR.
How is ARR different from Return on Investment (ROI)? This is a great question because they sound similar. The main difference is that ARR measures the average annual profit as a percentage of the investment, giving you a yearly performance metric. ROI, on the other hand, typically measures the total return over the entire life of an investment. ARR gives you a sense of the ongoing profitability, while ROI gives you the big-picture result from start to finish.
Does ARR only work for physical assets like machinery? Not at all. While it's commonly used for equipment purchases, ARR is a versatile tool you can apply to a wide range of investments. You can use it to evaluate the potential return on a new marketing campaign, a software implementation, a real estate purchase, or the development of a new product feature. As long as you can estimate the initial investment and the average annual profit it will generate, you can calculate an ARR.
Former Root, EVP of Finance/Data at multiple FinTech startups
Jason Kyle Berwanger: An accomplished two-time entrepreneur, polyglot in finance, data & tech with 15 years of expertise. Builder, practitioner, leader—pioneering multiple ERP implementations and data solutions. Catalyst behind a 6% gross margin improvement with a sub-90-day IPO at Root insurance, powered by his vision & platform. Having held virtually every role from accountant to finance systems to finance exec, he brings a rare and noteworthy perspective in rethinking the finance tooling landscape.