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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...