What is a Return on Risk-Adjusted Capital?

Return on risk-adjusted capital refers to a financial ratio that firms use to determine the effects of the interplay between 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 risk level for the amount of capital involved. This ratio allows them to compare investments with different risk profiles.

The concept of return on risk-adjusted capital was first introduced into the financial services industry in the late 1970s. Over the years, the use of the ratio has spread, and most commercial banks and some trading houses now use the ratio or a variation of it. Non-banking firms also use the ratio to measure the impact of credit, market and operational risk.

The concept behind the ratio 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 capital adjusted for maximum potential loss. A high ratio could be because of high return, low capital or low risk. Determining which risk to include in the calculations and the exact value of the components in the calculations, however, involves complex estimations. 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 from different sectors can modify return on risk-adjusted capital to incorporate each firm's unique features, such as business model and cash flow projections. Another benefit of this ratio is that it can incorporate different types of risks in a single framework, so that managers can better understand how the interrelationship between different risks affect the bottom line. Moreover, this ratio 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 firm needs a risk management department that monitors and controls the risks that the firm undertakes. Risk managers collect risk data, analyze it and discuss its implications with business managers. The firm can set a limit on the risk that it is willing to undertake so that risk managers can act quickly to mitigate risk when the return on risk-adjusted capital falls below the limit.