What Is Return on Risk-Adjusted Capital (RORAC)?

What Is Return on Risk-Adjusted Capital (RORAC)?

Let me explain what Return on Risk-Adjusted Capital, or RORAC, really is. It's a rate of return measure I often see in financial analysis, where you evaluate various projects, endeavors, and investments based on the capital at risk. Once you've calculated the individual RORAC values for projects with different risk profiles, it becomes much easier to compare them directly.

RORAC is similar to return on equity (ROE), but here's the key difference: the denominator gets adjusted to account for the project's risk.

The Formula for RORAC

You calculate Return on Risk-Adjusted Capital by dividing a company’s net income by the risk-weighted assets. The formula looks like this: Return on Risk Adjusted Capital = Net Income / Risk-Weighted Assets, where Risk-Weighted Assets = Allocated risk capital, economic capital, or value at risk.

What Does Return on Risk-Adjusted Capital Tell You?

RORAC takes into account the capital at risk, whether it's for a project or a company division. Allocated risk capital is the firm's capital, adjusted for a maximum potential loss based on estimated future earnings distributions or the volatility of earnings.

Companies like yours might use RORAC to emphasize firm-wide risk management. For instance, different corporate divisions with their own managers can apply RORAC to quantify and maintain acceptable risk-exposure levels.

This calculation is similar to risk-adjusted return on capital (RAROC). But with RORAC, the capital gets adjusted for risk, not the rate of return. You use RORAC when the risk varies depending on the capital asset being analyzed.

Example of How to Use RORAC

Assume a firm is evaluating two projects it engaged in over the previous year and needs to decide which one to eliminate. Project A had total revenues of $100,000 and total expenses of $50,000. The total risk-weighted assets involved in the project is $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 for the two projects is calculated as: Project A RORAC = ($100,000 - $50,000) / $400,000 = 12.5%, and Project B RORAC = ($200,000 - $100,000) / $900,000 = 11.1%.

Even though Project B had twice as much revenue as Project A, once you account for the risk-weighted capital of each project, it's 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. Risk-adjusted return on capital (RAROC) is usually defined as the ratio of risk-adjusted return to economic capital. In this calculation, instead of adjusting the risk of the capital itself, it's the risk of the return that gets quantified and measured. Often, you divide the expected return of a project by value at risk (VaR) to arrive at RAROC.

Another statistic similar to RORAC is the risk-adjusted return on risk-adjusted capital (RARORAC). You calculate this by taking the risk-adjusted return and dividing it by economic capital, adjusting for diversification benefits. It follows guidelines defined by the international risk standards in Basel III, which are reforms set to be implemented by Jan. 1, 2022, aimed at improving regulation, supervision, and risk management in the banking sector.

Limitations of Using Return on Risk-Adjusted Capital – RORAC

Calculating the risk-adjusted capital can be cumbersome because it requires understanding the value at risk calculation. For related insight, you should read more about how risk-weighted assets are calculated based on capital risk.