Which one of the following is a correct formula for computing the Return on Equity (ROE)?

• A. ROE = \frac{Net\ Income}{Average\ Shareholders'\ Equity}
• B. ROE = \frac{Total\ Assets}{Net\ Income}
• C. ROE = \frac{Net\ Income}{Total\ Liabilities}
• D. ROE = \frac{Gross\ Profit}{Shareholders'\ Equity}

Answer: (A)

Verified step by step guidance

1. Step 1: Understand the concept of Return on Equity (ROE). ROE is a financial ratio that measures the profitability of a company in relation to its shareholders' equity. It indicates how effectively the company is using the equity invested by shareholders to generate profits.
2. Step 2: Identify the correct formula for ROE. The formula is ROE = \frac{Net\ Income}{Average\ Shareholders'\ Equity}. This formula calculates the percentage return generated on the equity invested by shareholders.
3. Step 3: Break down the components of the formula: Net Income represents the company's profit after all expenses, taxes, and costs have been deducted. Average Shareholders' Equity is the average of the equity at the beginning and end of the period being analyzed.
4. Step 4: Compare the given options to the correct formula. The correct formula matches the first option: ROE = \frac{Net\ Income}{Average\ Shareholders'\ Equity}. The other options are incorrect because they use inappropriate components such as Total Assets, Total Liabilities, or Gross Profit.
5. Step 5: Apply the formula in practice by substituting the values for Net Income and Average Shareholders' Equity from the financial statements of a company to compute the ROE. This will provide insight into the company's profitability relative to shareholder investment.