Financial Statement Analysis of Leverage and How It Informs About Profitability and Price-to-Book Ratios

Doron Nissim () and Stephen H. Penman ()
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Doron Nissim: Columbia University
Stephen H. Penman: Columbia University

Review of Accounting Studies, 2003, vol. 8, issue 4, No 5, 560 pages

Abstract: Abstract This paper presents a financial statement analysis that distinguishes leverage that arises in financing activities from leverage that arises in operations. The analysis yields two leveraging equations, one for borrowing to finance operations and one for borrowing in the course of operations. These leveraging equations describe how the two types of leverage affect book rates of return on equity. An empirical analysis shows that the financial statement analysis explains cross-sectional differences in current and future rates of return as well as price-to-book ratios, which are based on expected rates of return on equity. The paper therefore concludes that balance sheet line items for operating liabilities are priced differently than those dealing with financing liabilities. Accordingly, financial statement analysis that distinguishes the two types of liabilities informs on future profitability and aids in the evaluation of appropriate price-to-book ratios.

Keywords: financing leverage; operating liability leverage; rate of return on equity; price-to-book ratio (search for similar items in EconPapers)
Date: 2003
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DOI: 10.1023/A:1027324317663

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