ARR and operating gearing

Your question on ARR is not completely clear to me, but I think what you are getting at is fundamentally the difference between Accounting Profit and Cash Flow.

There are basically 4 screening methods used by businesses around the world to evaluate their investment opportunities – ARR is one of these methods.

ARR is based on the Accounting Profit measurement and it is a useful method of Investment Appraisal because it lends itself easily to comparisons with that other performance measurement based on Accounting profits; ROCE.

Do you understand ROCE, which is defined as PBIT / Capital Employed ….

Normally, ARR is defined as average annual profits / average capital employed.

In the case of ARR, the numerator is defined as the average annual profit after depreciation but before tax. The denominator is normally defined as the average investment, which in turn is defined as the Initial Investment + Residual Income / divided by 2.

ARR is exactly the same concept, only ROCE is “backward” looking while ARR is “forward” looking. Another way of saying this is, ROCE measures the ACTUAL return of the company, division or industry for a period (say a year) whereas ARR measures the FORECAST or BUDGETED annual return on the proposed investment.

Decision Rule – Accept project if it is believed (forecasted) to earn a return, as measured by ARR, greater than the existing company (or industry) return as measured by ROCE.

ROCE is widely used in business practice for measuring SHORT-TERM company/divisional performance – say for periods of up to about a year. But over the LONGER TERM (the whole life of the project) what really matters is CASH FLOW. In the context of Investment Appraisal, it is here that we have one of the major problems associated with ARR – it ignores the TIME VALUE of money. Accounting profit is fine for measuring performance over a short period but cash is the appropriate measure when considering the performance over the life of a project.

There are of course yet further problems associated with the use of ARR in Investment Decision Making. Try to remember that the essential feature of Investment Decisions is TIME.

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Operating Gearing (or Operational Gearing), looks at the relationship between Contribution and Fixed Costs (or the split in the operating costs between Fixed Costs and Variable Costs).

Like Financial Gearing, there are several ways of measuring Operating Gearing -I like, FC / VC (Fixed Costs divided by Variable Costs). So, a company with a “relatively” high proportion of fixed costs to variable costs will be said to have high operating gearing.

Operating gearing is important because it is a measure of the sensitivity of company profit to the volume of activity achieved.

For example, when operating gearing is relatively high it will take only a small change in volume to effect a large change in profit.

In other words, any increase in volume will cause a disproportionate increase in profit. While any decrease in volume will cause a disproportionately greater decrease in profit.

As a generalization, activities that are capital intensive tend to have high operating gearing. Another example, supermarkets often have a lot of fixed costs – rent, salaries, heat and light, training and advertising, etc., which tends to give rise to high operating gearing. Consequently, just a small increase in sales revenue can lead to a much higher increase in profits.

Finally, higher operating gearing as well as higher financial both bring higher risks for the shareholders.

I do hope this little tutorial has helped to clarify these two issues for you.

Regards, Kevin Kelly