What is return on risk-adjusted capital (RORAC)?
Return on Risk-Adjusted Capital (RORAC) is a rate of return measure commonly used in financial analysis, where various projects, efforts and investments are evaluated based on venture capital. projects with different risk profiles are easier to compare with each other once their individual RORAC values have been calculated.
RORAC is similar to return on equity (ROE), except that the denominator is adjusted to account for a project’s risk.
Key points to remember
- Return on Risk-Adjusted Capital (RORAC) is commonly used in financial analysis, where various projects or investments are valued based on capital at risk.
- RORAC allows an apples-to-apples comparison of projects with different risk profiles.
- Similar to risk-adjusted return on capital, RAROC differs in that it adjusts return for risk, not capital.
The RORAC formula is
Risk-adjusted return on capital is calculated by dividing a company’s net income by risk-weighted assets.
Risk-adjusted return on capital
=
Net revenue
Risk-weighted assets
where:
Risk-weighted assets = Allocated, economic risk capital
capital or value at risk
\begin{aligned} &\text{Return on Risk Adjusted Capital}=\frac{\text{Net Income}}{\text{Risk-Weighted Assets}}\\ &\textbf{where:}\\ &\text {Risk-weighted assets = allocated, economic risk capital}\\ &\text{capital or value at risk}\\ \end{aligned} Risk-adjusted return on capital=Risk-weighted assetsNet revenuewhere:Risk-weighted assets = Allocated, economic risk capitalcapital or value at risk
What does risk-adjusted return on capital tell you?
The return on risk-adjusted capital (RORAC) takes into account the capital at risk, whether it is linked to a project or a division of the company. Allocated risk capital is the capital of the business, adjusted for maximum potential loss based on estimated future earnings distributions or earnings volatility.
Companies are using RORAC to put more emphasis on enterprise-wide risk management. For example, different business divisions with unique managers can use RORAC to quantify and maintain acceptable risk exposure levels.
This calculation is similar to risk-adjusted return on capital (RAROC). With RORAC, however, capital is adjusted for risk, not rate of return. The RORAC is used when the risk varies according to the asset analyzed.
Example of using RORAC
Suppose a company evaluates two projects it has engaged in over the past year and must decide which one to eliminate. Project A had total income of $100,000 and total expenses of $50,000. The total risk-weighted assets involved in the project are $400,000.
Project B had total revenues of $200,000 and total expenses of $100,000. The total risk-weighted assets involved in Project B is $900,000. The RORAC of the two projects is calculated as follows:
Project A RORAC
=
$
1
0
0
,
0
0
0
−
$
5
0
,
0
0
0
$
4
0
0
,
0
0
0
=
1
2
.
5
%
BR RORAC project
=
$
2
0
0
,
0
0
0
−
$
1
0
0
,
0
0
0
$
9
0
0
,
0
0
0
=
1
1
.
1
%
\begin{aligned} &\text{Project A RORAC}=\frac{\$100,000-\$50,000}{\$400,000}=12.5\%\\ &\text{Project B RORAC}=\frac{\$200,000-\$100,000 }{\$900,000}=11.1\%\\ \end{aligned} Project A RORAC=$400,000$100,000−$50,000=12.5%BR RORAC project=$900,000$200,000−$100,000=11.1%
Even though Project B had twice the revenue of Project A, once the risk-weighted capital of each project is taken into account, it is clear that Project A has a better RORAC.
The difference between RORAC and RAROC
RORAC is similar to, and easily confused with, two other statistics. Return on risk-adjusted capital (RAROC) is generally defined as the ratio of risk-adjusted return at economic capital. In this calculation, instead of adjusting the capital risk itself, it is the return risk that is quantified and measured. Often the expected return of a project is divided by value at risk (VaR) to arrive at RAROC.
Another statistic similar to RORAC is the risk-adjusted return on risk-adjusted capital (RARORAC). This statistic is calculated by taking the risk-adjusted return and dividing it by the economic capital, taking into account the benefits of diversification. It uses the guidelines defined by the international risk standards covered by Basel III– which is a set of reforms to be implemented by January 1, 2022 and which aims to improve regulation, supervision and risk management within the banking sector.
Limitations of the use of risk-adjusted return on capital – RORAC
Calculating risk-adjusted capital can be tedious because it requires an understanding of value-at-risk calculation.
For related information, learn more about how risk-weighted assets are calculated venture capital based.