# How to Calculate Return on Risk-Adjusted Capital (RORAC) with Examples

![Return on Risk-Adjusted Capital (RORAC)](https://www.investopedia.com/thmb/z0T9uGoV6OKisn89EEjjKbg5D1E=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/TermDefinitions_returnonrisk-51ccb3a2ebcb462da895b48fcd6ac432.jpg)

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

Return on risk-adjusted capital (RORAC) measures the rate of return. It is important in financial analysis because it evaluates projects and investments based on [capital risk](https://www.investopedia.com/terms/c/capital-risk-car.asp). RORAC is used when comparing projects with different risk profiles and it assists in strategic planning and risk management.

RORAC makes it easier to compare projects with different [risk profiles](https://www.investopedia.com/terms/r/risk-profile.asp) by adjusting the denominator for risk, which sets it apart from metrics like ROE and RAROC.

You can calculate RORAC by dividing a company’s net income by the risk-weighted assets.

### Key Takeaways

*   RORAC measures a project's profitability by comparing net income to risk-weighted assets, offering insights into risk-adjusted performance.
*   Unlike RAROC, which adjusts returns, RORAC adjusts the capital, focusing on how risk impacts returns.
*   RORAC helps companies make informed decisions by evaluating risk and return, aiding in strategic planning and risk management.
*   A project's lower revenue might result in a higher RORAC, highlighting its value when risk is considered.
*   Calculating RORAC can be complex, as it requires understanding risk-weighted assets and value at risk.

## Calculating RORAC: A Step-by-Step Guide

Return on risk-adjusted capital (RORAC) is calculated by dividing a company’s net income by the risk-weighted assets.

$\begin{aligned} &\text{Return on Risk Adjusted Capital}=\frac{\text{Net Income}}{\text{Risk-Weighted Assets}}\\ &\textbf{where:}\\ &\text{Risk-Weighted Assets = Allocated risk capital, economic}\\ &\text{capital, or value at risk}\\ \end{aligned}$

## In-Depth Look at RORAC and Its Importance

Return on risk-adjusted capital (RORAC) takes into account the capital at risk, whether it be related to a project or 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 use RORAC for firm-wide risk management, allowing divisions to measure and manage acceptable risk levels.

Unlike [risk-adjusted return on capital (RAROC)](https://www.investopedia.com/terms/r/raroc.asp), which adjusts returns for risk, RORAC adjusts capital and is used when the risk varies by capital asset.

## Real-World Example: Leveraging RORAC for Strategic Decisions

Assume a firm is evaluating two projects it has engaged in over the previous year and needs to decide which one to eliminate. Project A had [total revenues](https://www.investopedia.com/terms/r/revenue.asp) 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 of the two projects is calculated as:

$\begin{aligned} &\text{Project A RORAC}=\frac{\$100,000-\$50,000}{\$400,000}=12.5\%\\ &\text{Project B RORAC}=\frac{\$200,000-\$100,000}{\$900,000}=11.1\%\\ \end{aligned}$

Project B earned twice the revenue, but after considering risk-weighted capital, Project A had a higher RORAC.

## RORAC vs. RAROC and RARORAC: Understanding the Differences

RORAC is often confused with two other statistics. Risk-adjusted return on capital (RAROC) is usually defined as the ratio of [risk-adjusted return](https://www.investopedia.com/terms/r/riskadjustedreturn.asp) to [economic capital](https://www.investopedia.com/terms/e/economic-capital.asp). This resembles RAROC, but RORAC adjusts capital for risk instead of the return. Often, the expected return of a project is divided by [value at risk (VaR)](https://www.investopedia.com/terms/v/var.asp) to arrive at RAROC.

A similar measure 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 economic capital](https://www.investopedia.com/articles/economics/08/economic-capital.asp), adjusting for diversification benefits. It uses guidelines defined by the international risk standards covered in [Basel III](https://www.investopedia.com/terms/b/basell-iii.asp)—which is a set for reforms that are to be implemented by Jan. 1, 2022, and is meant to improve the regulation, supervision, and risk management within the banking sector.

## Key Limitations of RORAC You Should Know

Calculating [risk-adjusted capital](https://www.investopedia.com/terms/a/adjusted-capital-ratio.asp) can be complex, requiring an understanding of value at risk.

For related insight, read more about how risk-weighted assets are calculated [based on capital risk](https://www.investopedia.com/terms/c/capitalrisk.asp).

## The Bottom Line

Return on risk-adjusted capital (RORAC) is a critical metric to evaluate the rate of return on investments relative to the capital at risk. It offers a clearer picture of potential financial outcomes.

By adjusting for risk, RORAC allows businesses to make more informed comparisons between projects or divisions with varying risk profiles. Project examples demonstrate how RORAC can help decision makers prioritize initiatives to deliver superior risk-adjusted returns. RORAC can also help companies enhance firm-wide risk management by establishing acceptable risk exposure levels across various divisions.

Calculating risk-adjusted capital can be complex, which requires a thorough understanding of value at risk (VaR).