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Thursday, February 22, 2018

Risk Adjusted ROIC

In our first article on Next Gen Enterprise Risk Management [LINK] we talked about a prevailing trend for managers to move beyond the esoteric ERM practices used to gather data across a company TO the importance of aligning Risk Management initiatives with the actual fabric of the business. In this article, we will explore in part how Risk Management can be connected to the Finance Department.

Business Decisions
As a risk manager, if you want to enable effective business-decisions, you need to frame a risk problem into a context that has direct relevance to the stakeholders you are facing. You will also need to speak their language so that they can relate to the information (not data) you are providing.

If you were to communicate with a quality control unit, the physical security team, product design, marketing, production or engineering, you might need to go through a separate process of “Risk Augmentation”. This process is akin to the Knowledge Management movement some years back that up-sold enterprise-wide data into a space that finished up defining KM as a “multidisciplinary approach to achieving organisational objectives by making the best use of knowledge” ~ Wikipedia [LINK].

Next Generation Risk Management is kind of in the same trajectory where risk managers translate coherent measures of uncertainty into usable metrics business unit leaders can act on directly and without translation.

In the realm of finance, a performance metric that is widely used by executive teams to gauge whether a typical business or product line is achieving its overarching financial objectives is to track the underlying Return on Invested Capital against the objective. When this exercise is done by financial risk managers, we can create a new and exciting metric which we’ll label as Risk-Adjusted Return on Invested Capital.

Return on Invested Capital
Return on Invested Capital is the amount that a company is making for every percentage point over the cost of capital, and the calculation is precariously simple: Net Income - Dividends / Total Capital. Don’t be fooled, simple things are rarely so in the crossover zone between risk and finance, and managers use this measure to gauge how well a company is using its capital to generate returns. You can gain insight into some of the detailing under ROIC here [LINK] but let’s not distract ourselves with the nuanced ROIC calculations for the time being.

When it comes to the finance department, business decisions are deemed successful if they generate economic value, that is a manager closes a project up in the green and in profit, ummm no. There is a chance opportunity cost has been ignored with that keep it simple view of what success is, and then, some people labour too hard for too long to capture their returns. Equally bad ideas come from when business managers take on tail risk for humble premiums ~ such things are not usually the outcome of good risk or data assessment or decision-marking, but foolish persistence.

Risk Adjusted ROIC | Causal Capital Notes

The key with the Risk-Adjusted ROIC metric is that it can give us insight into whether past decisions have been [1] in line with the firm’s risk appetite if that has has been formally recorded and ... [2] whether those decisions have been effective or not. In a sense, the Risk-Adjusted ROIC is less of an edge detector for risk managers but more of a historical tracker of effective decision-making through time ... yes !!! Sometimes in risk management, it’s good to look back and learn from the past.

Wonderful, BUT this is ROIC, where is the Risk Adjusted component, it seems to be missing!

We’ll talk about that in part II of our posting which will be published later on in the week all faring well, but we can't talk about Risk Adjusted ROIC until we are familiar with ROIC [LINK].

Anyway, stay tuned, there is more to follow.

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