RAROS: the dynamic tool that boosts shareholder value
In this article, Job Wolters looks at how companies can gain detailed insight into the risk-adjusted profitability of individual projects and transactions, and explains how the Risk Adjusted Return On Sales (RAROS) concept can benefit your bottom line.
As outlined in a recent Zanders article by Laurens Tijdhof, integration between treasury and the business is an important prerequisite for treasury to be a pro-active, strategic advisor to the wider company. The article discussed the quantification of financial risks in the commercial process and how this can enable treasury to add value to the business.
The benefits of incorporating risk into performance management have been acknowledged in many surveys. Companies struggle, however, in the practical application. Present techniques used by corporates are mainly qualitative in nature and mostly consist of ad hoc risk adjustments in the case of quantitative assessments. Therefore, the need for a risk-adjusted performance measurement that is able to quantify risk is both evident and challenging.
Risk Adjusted Return on Sales
By introducing the Risk Adjusted Return On Sales (RAROS) concept, a company can gain more insight into the true risk-adjusted profitability of individual projects and business transactions. It can serve as a primary tool for CFOs, controllers and treasurers to integrate financial risk management in day-to-day business processes and business decisions. RAROS is a risk-adjusted performance measure that adjusts the gross profit margin of a business transaction for various financial risk factors (e.g. FX, commodity price risk, credit risk and working capital risk) resulting from this transaction by determining a discount factor, based on a risk-free rate and a risk premium.
By acknowledging the fact that growth does not necessarily equate to economic profit, RAROS helps companies to adopt an improved view with respect to the evaluation of business transactions. RAROS is more informative compared to a plain, non-risk adjusted gross margin as a performance measurement as transactions always involve financial risks. By quantifying these financial risks, corporates gain a better insight into the true economic value of a business transaction, and overall this provides more assurance that corporates’ objectives are achieved. Because, in the end, the overall objective of RAROS is to enhance shareholder value.
Zanders’ RAROS methodology
Zanders’ proprietary RAROS methodology is based on various existing best practices which link risk and performance, as used by both financial institutions (e.g. Risk Adjusted Return on Capital) and corporates (e.g. Risk Adjusted Forecasting, Capital Budgeting and Economic Value Added). The most important differentiator of RAROS is related to the level of granularity. The objective of RAROS is to be a dynamic measurement tool providing very specific risk quantification for individual business transactions. In addition, RAROS takes into account the potential interdependencies (correlations) between financial risks. Analyzing correlations in an exact manner is a daunting task but it is of key importance for correctly quantifying diversification effects.
In short, RAROS is a ‘next practice’ example of how treasury can integrate with the business by improving financial risk management in day-to-day business processes and business decisions. RAROS enables companies to increase their risk awareness across different departments. It can be implemented as a key performance indicator, providing insight into the true economic profit of business transactions. Finally, RAROS can be used as a strategic decision-making tool. While working alongside the financial planning & analysis function, controllerships, and the sales & procurement department, treasury should take a lead role in the implementation of RAROS as the expert in financial risk quantification and risk management.