Financial Statement Analysis

Review of Accounting Studies, 8, 531–560, 2003

# 2003 Kluwer Academic Publishers. Manufactured in The Netherlands.

Financial Statement Analysis of Leverage and How It

Informs About Profitability and Price-to-Book Ratios

DORON NISSIM

dn75@columbia.edu

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

STEPHEN H. PENMAN

shp38@columbia.edu

Graduate School of Business, Columbia University, 3022 Broadway, Uris Hall 612, New York, NY 10027

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.

Keywords: financing leverage, operating liability leverage, rate of return on equity, price-to-book ratio

JEL Classification: M41, G32

Leverage is traditionally viewed as arising from financing activities: Firms borrow to

raise cash for operations. This paper shows that, for the purposes of analyzing

profitability and valuing firms, two types of leverage are relevant, one indeed arising

from financing activities but another from operating activities. The paper supplies a

financial statement analysis of the two types of leverage that explains...