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

45 Pages Posted: 8 Dec 2001

See all articles by Doron Nissim

Doron Nissim

Columbia University - Columbia Business School

Stephen H. Penman

Columbia Business School - Department of Accounting

Date Written: October 2001

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 in 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 aids in the forecasting of future profitability and the evaluation of appropriate price-to-book ratios.

Keywords: Financing leverage; Operating liability leverage; Rate of return on equity; Price-to-book ratio

JEL Classification: G12, M41

Suggested Citation

Nissim, Doron and Penman, Stephen H., Financial Statement Analysis of Leverage and How it Informs About Profitability and Price-to-Book Ratios (October 2001). Available at SSRN: https://ssrn.com/abstract=292725 or http://dx.doi.org/10.2139/ssrn.292725

Doron Nissim (Contact Author)

Columbia University - Columbia Business School ( email )

3022 Broadway
604 Uris Hall
New York, NY 10027
United States
212-854-4249 (Phone)

Stephen H. Penman

Columbia Business School - Department of Accounting ( email )

3022 Broadway
New York, NY 10027
United States
212-854-9151 (Phone)
212-316-9219 (Fax)

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