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

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

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: Recall the formula for ROE. The correct formula is ROE = \( \frac{\text{Net Income}}{\text{Average Shareholders' Equity}} \). This formula highlights the relationship between the company's net income and the average equity provided by shareholders.
3. Step 3: Analyze the options provided in the problem. Compare each formula to the correct ROE formula: \( \frac{\text{Net Income}}{\text{Average Shareholders' Equity}} \). Eliminate formulas that do not align with the definition of ROE.
4. Step 4: Note that \( \frac{\text{Gross Profit}}{\text{Shareholders' Equity}} \), \( \frac{\text{Net Income}}{\text{Total Liabilities}} \), and \( \frac{\text{Total Assets}}{\text{Net Income}} \) are incorrect because they do not measure profitability relative to shareholders' equity.
5. Step 5: Confirm that the correct formula for ROE is \( \frac{\text{Net Income}}{\text{Average Shareholders' Equity}} \), as it accurately reflects the relationship between net income and shareholders' equity.