Which of the following is the correct formula for calculating Return on Equity (ROE)?

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

Answer: (D)

Verified step by step guidance

1. Step 1: Understand the concept of Return on Equity (ROE). ROE is a financial ratio that measures a company's ability to generate profit from its shareholders' equity. It indicates how effectively the company is using the money invested by its shareholders to generate earnings.
2. Step 2: Identify the correct formula for ROE. The formula is ROE = \frac{Net\ Income}{Average\ Shareholders'\ Equity}. This formula divides the net income (profit after all expenses, taxes, and interest) by the average shareholders' equity (the average of the equity at the beginning and end of the period).
3. Step 3: Break down the components of the formula: \text{Net Income} is the profit earned during a specific period, and \text{Average Shareholders' Equity} is calculated as \frac{Beginning\ Equity + Ending\ Equity}{2}. This ensures the equity value reflects changes over the period.
4. Step 4: Understand why the other formulas provided are incorrect. For example, \frac{Total\ Assets}{Net\ Income} measures asset efficiency, not ROE. Similarly, \frac{Gross\ Profit}{Shareholders'\ Equity} uses gross profit instead of net income, which is not appropriate for ROE. \frac{Net\ Income}{Total\ Liabilities} measures profitability relative to liabilities, not equity.
5. Step 5: Apply the correct formula to calculate ROE in practice. Gather the net income and average shareholders' equity from the financial statements, substitute them into the formula \frac{Net\ Income}{Average\ Shareholders'\ Equity}, and compute the ratio to assess the company's performance.