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

Review of Accounting Studies volume 8, pages531–560(2003)Cite this article

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.

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Affiliations

  1. Graduate School of Business, Columbia University, 3022 Broadway, Uris Hall 604, New York, NY, 10027

    Doron Nissim & Stephen H. Penman

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  1. Doron Nissim
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  2. Stephen H. Penman
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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

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