What does the Return on common stockholders' equity consider?

The Return on common stockholders' equity (ROE) is a financial metric that evaluates how effectively a company uses the equity invested by common stockholders to generate profits. The correct formulation for ROE is net income minus preferred dividends divided by average common stockholders' equity.

This calculation reflects the amount of net income that is available to common shareholders after accounting for the dividends owed to preferred shareholders. By using average common stockholders' equity in the denominator, ROE provides a measure of the returns generated relative to the equity that is actually invested by common shareholders over a specific period.

In contrast, the other options do not accurately reflect the definition or calculation of ROE. Net income before taxes does not account for the preferred dividends that must be deducted, while gross profit divided by total sales pertains to profitability analysis rather than equity efficiency. Lastly, net income divided by total liabilities measures a company’s ability to cover its debts rather than the returns to equity holders. Thus, the correct choice represents a clear and specific interpretation of how effectively a business employs its equity to generate returns for its common stockholders.