Chartered Financial Analyst (CFA) Level 1 Practice Exam

How is Return on Equity (ROE) calculated?

1. Net Income / Average Total Equity

2. Net Income / Total Assets

3. Operating Income / Total Equity

4. Gross Income / Average Common Equity

The correct answer is: Net Income / Average Total Equity

Return on Equity (ROE) is calculated by dividing net income by the average equity attributable to common shareholders. This metric measures a company's profitability relative to the equity held by its shareholders, indicating how effectively the company is using that equity to generate profits. Using net income in the numerator provides a clear representation of the profits available to shareholders after all expenses, taxes, and costs have been deducted. The average total equity in the denominator accounts for changes in equity over time, offering a more accurate reflection of the capital that has been invested by the shareholders throughout the accounting period. This ratio is important for investors because it demonstrates how well a company is utilizing shareholders' funds to create earnings. A higher ROE suggests that a company is effectively generating income compared to its equity base, which can be a positive sign for potential investors. The other options provide different financial ratios that measure other aspects of a company's performance but do not accurately represent the calculation of ROE. For instance, using total assets or operating income in the calculations pertains to different financial metrics, such as Return on Assets (ROA) or various forms of profitability ratios, which are not interchangeable with ROE.