Ratio Analysis Using the DuPont Model

Apple and Microsoft

Is Apple providing a return to the equity investors? Is Apple doing better than Microsoft and other competitors in this industry? Yes, it is currently providing a fantastic return to its equity investors! We can see that Apples return on equity is 41.67%. This indicates that for every $100 of equity capital, Apple is able to generate $41.67 in net income. We also see that Microsofts return on equity is higher than Apples return on equity!

Well, if Apples return on assets is higher than Microsofts return on assets, why is it that Apple still has a lower return on equity?

Understanding the leverage ratio of Apple and Microsoft will help you understand why Apples return on equity is lower than that of Microsoft even though Apple has a higher return on assets than Microsofts return on assets Companies use debt as a source of finance to increase assets or earning capacity.

The leverage ratio reflects the capital structure of the firm. We can see that Apples leverage is 1.54 and Microsofts leverage is 1.89. Because Microsofts higher leverage of 1.89 is multiplied by its return on assets, it is able to generate a higher return on equity than Apple despite having a lower return on equity than Apple.

Why is Apple able to generate a higher return on assets than Microsoft? We can answer this question by breaking down the return on assets into its separate components. How is the return on assets equal to the product of the profit margin multiplied by the asset turnover? We can see that the net sales in the profit margin ratio and the asset turnover ratio cancel out and you are left with the components of the return on assets.

Profit Margin: The profit margin reflects the profitability of the company or the margin that the company is able to keep on its sales. If a company has a dollar of sales or revenue and it cost the company 80 cents to generate the sales, we would say it has a 20% profit margin (computed as (($10.80)/$1)*100% = 20% profit margin). In other words the profit margin reflects the excess of selling price over costs as a percentage of the selling price. The profit margin of a company is arrived at by dividing its net income by its net revenues.

The asset turnover ratio reflects how many dollars of sales the company was able to generate out of each dollar of assets it has. The asset turnover ratio shows how effectively the company has used its assets to generate sales.

When we look at the profit margin and asset turn over ratios of Apple and Microsoft, we can see that Microsoft is able to generate a higher profit margin. However, Apple has a higher asset turnover ratio indicating that it is able to generate more sales from its assets and therefore ends up with a higher return on its assets.