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

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  • Doron Nissim

    (Columbia University)

  • Stephen H. Penman

    (Columbia University)

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.

Suggested Citation

  • Doron Nissim & Stephen H. Penman, 2003. "Financial Statement Analysis of Leverage and How It Informs About Profitability and Price-to-Book Ratios," Review of Accounting Studies, Springer, vol. 8(4), pages 531-560, December.
    • Handle: RePEc:spr:reaccs:v:8:y:2003:i:4:d:10.1023_a:1027324317663
    DOI: 10.1023/A:1027324317663
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    References listed on IDEAS

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    1. Petersen, Mitchell A & Rajan, Raghuram G, 1997. "Trade Credit: Theories and Evidence," The Review of Financial Studies, Society for Financial Studies, vol. 10(3), pages 661-691.
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    3. Zhang, Xiao-Jun, 2000. "Conservative accounting and equity valuation," Journal of Accounting and Economics, Elsevier, vol. 29(1), pages 125-149, February.
    4. Smith, Janet Kiholm, 1987. "Trade Credit and Informational Asymmetry," Journal of Finance, American Finance Association, vol. 42(4), pages 863-872, September.
    5. Schwartz, Robert A., 1974. "An Economic Model of Trade Credit," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 9(4), pages 643-657, September.
    6. Rajan, Raghuram G & Zingales, Luigi, 1995. "What Do We Know about Capital Structure? Some Evidence from International Data," Journal of Finance, American Finance Association, vol. 50(5), pages 1421-1460, December.
    7. Doron Nissim & Stephen H. Penman, 2001. "Ratio Analysis and Equity Valuation: From Research to Practice," Review of Accounting Studies, Springer, vol. 6(1), pages 109-154, March.
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    Cited by:

    1. Adam Esplin & Max Hewitt & Marlene Plumlee & Teri Lombardi Yohn, 2014. "Disaggregating operating and financial activities: implications for forecasts of profitability," Review of Accounting Studies, Springer, vol. 19(1), pages 328-362, March.

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