YouScience Accounting 1 Practice Exam

Return on equity shows how much profit a company generates from the capital provided by shareholders. The correct formula uses net income in the numerator because it reflects all expenses and taxes, representing actual profit, not just sales. The denominator uses average shareholders' equity to account for changes in equity over the period, giving a more accurate picture of how effectively the owners’ funds are being used. Averages smooth out fluctuations from activities like issuing new shares, buybacks, or retained earnings.

Using revenue would measure sales relative to equity, not profitability after costs. Dividing by total assets mixes financing with the asset base rather than focusing on owners’ funds. Using current liabilities targets short-term obligations, not the owners’ stake. Using gross margin divided by equity ignores many expenses and taxes and isn’t a measure of return on equity.