Off-Balance-Sheet Assets, Financial Leverage, and Stock Returns

Abstract

This paper examines the cross-sectional relation between leverage and future stock returns. Research documents a puzzling non-positive correlation. We show it is largely caused by firms’ reliance on internal financing when they have significant investments in off-balance-sheet assets. Firms with a high cost of equity financing thus can have low leverage, creating a negative correlation between leverage and future stock returns. This phenomenon is more pronounced among firms with low leverage, resulting in an overall check-mark-shaped relationship between leverage and future stock returns.

Keywords: Leverage, Off-Balance-Sheet Assets, Investments, Conservative Accounting, Financial Assets, Stock Returns.

JEL Classification: M41, G12, G32, H26