ROE is defined as which ratio?

ROE is defined as which ratio?

• A. Net income divided by total assets.
• B. Net income divided by average shareholders' equity.
• C. Revenue divided by average equity.
• D. Earnings before interest and taxes divided by equity.

Answer: (B)

Return on equity measures how efficiently shareholders’ funds are turned into profit. It looks at the profit earned for each dollar of equity invested, so the numerator must be net income (the earnings actually available to shareholders after taxes and financing costs). Using average shareholders’ equity over the period smooths out when equity changes during the year, giving a fair view of returns over time. This is why net income divided by average shareholders’ equity is the best representation. Using total assets would give return on assets, which gauges overall asset efficiency rather than equity profitability. Revenue divided by average equity ignores costs and profits, focusing on sales instead. Earnings before interest and taxes divided by equity omits taxes and interest, so it isn’t the true return to equity holders.

Return on equity measures how efficiently shareholders’ funds are turned into profit. It looks at the profit earned for each dollar of equity invested, so the numerator must be net income (the earnings actually available to shareholders after taxes and financing costs). Using average shareholders’ equity over the period smooths out when equity changes during the year, giving a fair view of returns over time.

This is why net income divided by average shareholders’ equity is the best representation. Using total assets would give return on assets, which gauges overall asset efficiency rather than equity profitability. Revenue divided by average equity ignores costs and profits, focusing on sales instead. Earnings before interest and taxes divided by equity omits taxes and interest, so it isn’t the true return to equity holders.