Risk-adjusted return on capital is a financial ratio used to measure the return on an investment while taking into account the risks involved. It is used to evaluate high-risk projects or investments and can be adjusted to incorporate different types of risks. A risk management department is needed to monitor and control risks.
Risk-adjusted return on capital refers to a financial ratio used by firms to determine the effects of the interaction of risk and return on shareholder value. In other words, it measures the return on an investment, taking into account the risks of the investment. Finance professionals use the ratio to evaluate projects or investments that have a high level of risk for the amount of capital involved. This report allows them to compare investments with different risk profiles.
The concept of risk-adjusted return on capital was first introduced in the financial services industry in the late 1970s. Over the years, use of the ratio has spread and most commercial banks and some trading houses now use the ratio or a variation thereof. Non-banking firms also use the ratio to measure the impact of credit, market and operational risk.
The concept behind the report is simple: the higher a project’s return on risk-adjusted capital, the greater its value in increasing shareholder wealth. In mathematical terms, it can be expressed as net income divided by principal adjusted for maximum potential loss. A high ratio could be due to high yield, low capital or low risk. Determining what risk to include in the calculations and the exact value of the components in the calculations, however, involves complex estimates. The figures in the calculations often fluctuate and are difficult to predict, such as when measuring the alpha and beta values of stocks.
Different firms in different industries can adjust the risk-adjusted return on capital to incorporate each firm’s unique characteristics, such as business model and cash flow projections. Another benefit of this report is that it can incorporate different types of risks into a single framework, so managers can better understand how the interrelationship between different risks affects bottom line. Additionally, this report is more useful than accounting-based financial reports, such as balance sheets or profit and loss statements, because it promotes a long-term view of risk and return.
To use the ratio effectively, a business needs a risk management department that monitors and controls the risks the business takes. Risk managers collect risk data, analyze it, and discuss its implications with corporate executives. The firm can set a limit on the risk it is willing to undertake so that risk managers can act quickly to mitigate the risk when the risk-adjusted return on capital falls below the limit.
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