ACCA Financial Management (F9) Certification Practice Exam

What is the formula used to determine Return on Equity?

1. Profits after interest and tax / Total Assets

2. Profits after interest and tax / Shareholders' funds

3. Operating profit / Total equity

4. Net income / Total liabilities

The correct answer is: Profits after interest and tax / Shareholders' funds

Return on Equity (ROE) is a financial metric that measures the ability of a company to generate profits from its shareholders' investments in the company. The formula for calculating ROE is derived by dividing the net income of the company, which represents the profits available to shareholders after all expenses, interest, and taxes have been deducted, by the total equity or shareholders' funds. This calculation effectively demonstrates how well a company is performing in relation to the equity invested by its shareholders. A higher ROE indicates that the company is efficiently utilizing the capital that shareholders have provided to achieve profitability, which is a key indicator of financial performance and management effectiveness. The other choices do not accurately reflect the definition of ROE. For example, profits after interest and tax divided by total assets reflects a different measure that does not specifically consider the equity provided by shareholders. Operating profit divided by total equity could illustrate operational efficiency but does not factor in non-operational costs, such as interest and taxes, which are essential components of net income. Lastly, dividing net income by total liabilities does not provide meaningful insight into the return on equity since it compares profits to borrowings rather than investments made by shareholders. Using the correct ROE formula allows shareholders and potential investors to gauge the company