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

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.

This is a preview of subscription content, access via your institution.

References

  1. Biais, B. and C. Gollier. (1997). “Trade Credit and Credit Rationing.” The Review of Financial Studies 10, 903-937.

    Google Scholar 

  2. Fama, E. and K. French. (1998). “Taxes, Financing Decisions, and Firm Value.” Journal of Finance 53, 819-843.

    Google Scholar 

  3. Fama, E. and J. MacBeth. (1973). “Risk, Return and Equilibrium: Empirical Tests.” Journal of Political Economy 81, 607-636.

    Google Scholar 

  4. Feltham, J. and J. Ohlson. (1995). “Valuation and Clean Surplus Accounting for Operating and Financing Activities.” Contemporary Accounting Research 11, 689-731.

    Google Scholar 

  5. Ferris, J. (1981). “A Transactions Theory of Trade Credit Use.” Quarterly Journal of Economics 94, 243- 270.

    Google Scholar 

  6. Harris, M. and A. Raviv. (1991). “The Theory of Capital Structure.” Journal of Finance 46, 297-355.

    Google Scholar 

  7. Kemsley, D. and D. Nissim. (2002). “Valuation of the Debt-tax Shield.” Journal of Finance 57, 2045-2074.

    Google Scholar 

  8. Masulis, R. (1988). The Debt/Equity Choice. Cambridge, MA: Ballinger Publishing Co.

    Google Scholar 

  9. Mian, S. and C. Smith, Jr. (1992). “Accounts Receivable Management Policy: Theory and Evidence.” Journal of Finance 47, 169-200.

    Google Scholar 

  10. Modigliani, F. and M. Miller. (1958). “The Cost of Capital, Corporation Finance, and the Theory of Investment.” American Economic Review 46, 261-297.

    Google Scholar 

  11. Modigliani, F. and M. Miller. (1963). “Corporation Income Taxes and the Cost of Capital: A Correction.” American Economic Review 53, 433-443.

    Google Scholar 

  12. Nissim, D. and S. Penman. (2001). “Ratio Analysis and Equity Valuation: From Research to Practice.” Review of Accounting Studies 6, 109-154.

    Google Scholar 

  13. Penman, S. (2004). Financial Statement Analysis and Security Valuation 2nd ed. New York: Irwin/ McGraw-Hill.

    Google Scholar 

  14. Petersen, M. and R. Rajan. (1997). “Trade Credit: Theories and Evidence.” The Review of Financial Studies 10, 661-691.

    Google Scholar 

  15. Rajan, R. and L. Zingales. (1995). “What Do We Know about Capital Structure Choice? Some Evidence from International Data.” Journal of Finance 50, 1421-1460.

    Google Scholar 

  16. Richardson, S., R. Sloan, M. Soliman and I. Tuna. (2002). “Information in Accruals about Earnings Persistence and Future Stock Returns.” Working paper, University of Michigan.

  17. Ross. S. (1977). “The Determination of Financial Structure: The Incentive-Signaling Approach.” Bell Journal of Economics 8, 23-40.

    Google Scholar 

  18. Schwartz, R. (1974). “An Economic Model of Trade Credit.” Journal of Financial and Quantitative Analysis 9, 643-657.

    Google Scholar 

  19. Sloan, R. G. (1996). “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings?” The Accounting Review 71, 289-315.

    Google Scholar 

  20. Smith, J. (1987). “Trade Credit and Information Asymmetry.” Journal of Finance 42, 863-872.

    Google Scholar 

  21. Titman, S. and R. Wessels. (1988). “The Determinants of Capital Structure Choice.” Journal of Finance 43, 1-19.

    Google Scholar 

  22. Zhang, X. (2000). “Conservative Accounting and Equity Valuation.” Journal of Accounting and Economics 29, 125-149.

    Google Scholar 

Download references

Author information

Affiliations

Authors

Rights and permissions

Reprints and Permissions

About this article

Cite this article

Nissim, D., Penman, S.H. Financial Statement Analysis of Leverage and How It Informs About Profitability and Price-to-Book Ratios. Review of Accounting Studies 8, 531–560 (2003). https://doi.org/10.1023/A:1027324317663

Download citation

  • financing leverage
  • operating liability leverage
  • rate of return on equity
  • price-to-book ratio