Chartered Financial Analyst (CFA) Level 1 Practice Exam

Which metric reflects the profitability available to common equity holders?

1. Return on Common Equity

2. Net Profit Margin

3. EBIT Margin

4. Return on Assets

The correct answer is: Return on Common Equity

Return on Common Equity is the metric that specifically measures the profitability available to common equity holders by assessing the amount of net income generated as a percentage of the common shareholders' equity. This ratio reflects how effectively a company is using the equity invested by its common shareholders to generate profit. It is a crucial metric for investors because it helps them understand the return they are receiving on their investment in the company. In contrast, other metrics like Net Profit Margin evaluate overall profitability relative to total revenues, but do not focus specifically on the equity holders. EBIT Margin deals with operating income before interest and taxes relative to revenue, which again does not consider the impact on equity holders. Return on Assets measures how efficiently a company utilizes its total assets to generate profit, but does not directly address the returns available specifically to common equity holders. Thus, Return on Common Equity provides the most relevant insight into profitability from the perspective of common equity shareholders.