What does the return on equity measure?

The return on equity (ROE) measures a company's ability to generate profit from its shareholders' equity. It is calculated by taking net income and dividing it by the average equity. This ratio provides insight into how effectively management is using shareholders' funds to create earnings. A higher ROE indicates a more efficient use of equity, which is favorable for investors, as it indicates better profitability relative to the equity invested in the company.

In understanding this, it is important to recognize that options referring to different combinations of net income, total assets, and equity do not accurately reflect the specific relationship that ROE is intended to measure. Only the correct formula focuses on the relationship between net income and equity, which is crucial for assessing financial performance from the perspective of shareholders.