Return on equity is calculated by dividing net income by which metric?

Return on equity is calculated by dividing net income by which metric?

• A. Total assets
• B. Net income
• C. Shareholders' equity
• D. Total liabilities

Answer: (C)

Return on equity shows how effectively a company turns the funds invested by shareholders into profit. It is calculated by dividing net income by the amount of shareholders’ equity. The numerator is net income, representing the profit earned in the period, and the denominator is shareholders’ equity, the owners’ claim on the company after liabilities are settled. This ratio directly reflects the return generated for owners, which is why it’s the standard measure investors look at. If you used total assets as the denominator, you’d get return on assets, which gauges how efficiently all assets are used, not specifically the owners’ funds. Using total liabilities as the denominator would produce a different kind of leverage-related metric, not the profitability measure investors seek for equity. Using net income as the denominator would be meaningless for assessing owner return, since it would collapse to a trivial value rather than showing how much profit is earned per dollar of equity.

Return on equity shows how effectively a company turns the funds invested by shareholders into profit. It is calculated by dividing net income by the amount of shareholders’ equity. The numerator is net income, representing the profit earned in the period, and the denominator is shareholders’ equity, the owners’ claim on the company after liabilities are settled. This ratio directly reflects the return generated for owners, which is why it’s the standard measure investors look at.

If you used total assets as the denominator, you’d get return on assets, which gauges how efficiently all assets are used, not specifically the owners’ funds. Using total liabilities as the denominator would produce a different kind of leverage-related metric, not the profitability measure investors seek for equity. Using net income as the denominator would be meaningless for assessing owner return, since it would collapse to a trivial value rather than showing how much profit is earned per dollar of equity.