Return on Equity (ROE) is calculated as which ratio?

Return on Equity (ROE) is calculated as which ratio?

• A. GROSS PROFIT / REVENUE
• B. NET INCOME / EQUITY
• C. NET INCOME / TOTAL ASSETS
• D. OPERATING INCOME / EQUITY

Answer: (D)

ROE shows how effectively owners’ funds are turned into profit. It uses after-tax earnings (net income) in relation to the shareholders’ equity. So the ratio is net income divided by equity, which tells you how much profit is generated for each dollar of owners’ investment. Using gross profit or revenue wouldn’t reflect costs and taxes, and using operating income ignores taxes and financing effects that affect what actually accrues to equity holders. Using total assets in the denominator would measure ROA, not ROE. That’s why net income over equity is the correct way to compute ROE.

ROE shows how effectively owners’ funds are turned into profit. It uses after-tax earnings (net income) in relation to the shareholders’ equity. So the ratio is net income divided by equity, which tells you how much profit is generated for each dollar of owners’ investment. Using gross profit or revenue wouldn’t reflect costs and taxes, and using operating income ignores taxes and financing effects that affect what actually accrues to equity holders. Using total assets in the denominator would measure ROA, not ROE. That’s why net income over equity is the correct way to compute ROE.