The limitations of using the accounting rate of return (ARR) method include its disregard for cash flow timing and risk.
The ARR method, while simple and straightforward, has several limitations that can impact its effectiveness in investment decision-making. One of the main limitations is that it does not take into account the timing of cash flows. In other words, it assumes that all cash inflows and outflows occur at the same time, which is rarely the case in real-world scenarios. This can lead to inaccurate calculations of return, as the value of money changes over time due to factors such as inflation and interest rates.
Another significant limitation of the ARR method is that it does not consider the risk associated with an investment. Different investments carry different levels of risk, and this risk can significantly impact the potential return. By not taking into account the risk factor, the ARR method may overestimate the return on high-risk investments and underestimate the return on low-risk investments.
Furthermore, the ARR method uses accounting profits rather than cash flows in its calculations. This can be problematic as accounting profits can be manipulated through various accounting practices, potentially leading to distorted results. Cash flows, on the other hand, are harder to manipulate and provide a more accurate reflection of an investment's profitability.
The ARR method also fails to consider the opportunity cost of capital. This is the return that could have been earned on the next best alternative investment. By not considering this, the ARR method may suggest that an investment is profitable when in fact, better returns could have been achieved elsewhere.
Lastly, the ARR method does not provide a clear indication of the payback period, i.e., the time it takes for an investment to recoup its initial outlay. This information is crucial for businesses as it helps them manage their cash flows and assess the liquidity risk associated with an investment.
In conclusion, while the ARR method can provide a quick and easy way to evaluate the potential return on an investment, its limitations mean that it should not be used in isolation. Other methods, such as the net present value (NPV) or internal rate of return (IRR), should also be used to provide a more comprehensive assessment of an investment's potential return.
