What is risk-adjusted return on capital

What is risk-adjusted return on capital (RAROC)? It’s a financial metric that balances profitability and risk. This corporate governance training guide will tell you more. 

Risk-adjusted return on capital (RAROC) is a metric used to assess the profitability of an investment, project, or even an entire business, adjusted for the risk it carries. 

Essentially, RAROC measures the strength of any financial return against the risk required to achieve it. It’s a standardised metric worldwide, so the trained mind will gain a lot from this one metric, and be able to tell a lot about a company’s primary business potential.  

Not only that, they will also be able to compare the performances of different business units, projects, or assets on a level playing field, regardless of their risk levels.

RAROC is crucial because the risk element gives a more accurate measure of an investment’s true profitability. 

This metric is particularly essential for financial institutions and investment firms, where managing risk exposure is as important as achieving high returns. RAROC enables these entities to compare the efficiency of different investments or projects, which may have varying levels of risk. 

The concept is also quite valuable for managers and investors in their decision-making. RAROC highlights potentially overvalued investments or underpriced risks. By quantifying these, RAROC helps us understand whether the return compensates adequately for the risk assumed.

Calculating RAROC involves a set equation that you should familiarise yourself with, even if you’re not the one who will use it day-to-day. 

The basic formula is:

Experts often expand “Net income” to the following: 

• Revenue
• MINUS operating costs
• MINUS liquidity costs
• MINUS: average losses

To put all this into practice, suppose a project generates a net income of €100,000 and the economic capital required, determined through risk assessment, is €1,000,000. The RAROC would then be 10%, indicating how much return the capital generates adjusted for the risk. This calculation helps businesses evaluate whether the returns justify the risk, guiding more nuanced investment and operational decisions.

It represents a company’s entire risk profile, expressed in terms of capital. 

In other words, it’s the amount of money a company stands to lose given its risk profile and the amount of money it, therefore needs in reserve to cover such a loss.

Risk-Adjusted Return on Capital (RAROC) is fundamental in contemporary financial analysis, offering a sophisticated tool for evaluating the profitability of investments about their risk profiles. 

By incorporating RAROC into their decision-making processes, corporate leaders can ensure more disciplined and rational capital allocation, enhance risk management, and ultimately drive sustainable growth. 

The figure also clearly establishes a relationship between risk and return, which is crucial for managers and investors.