Financial Statement Analysis

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Financial Statement Analysis of Leverage and How It Informs
About Profitability and Price-to-Book Ratios
Doron Nissim
Columbia University
Graduate School of Business
3022 Broadway, Uris Hall 604
New York, NY 10027
(212) 854-4249, dn75@columbia.edu
and
Stephen H. Penman
Columbia University
Graduate School of Business
3022 Broadway, Uris Hall 612
New York, NY 10027
(212) 854-9151, shp38@columbia.edu
October 2001
We received helpful comments from Nir Yehuda and from seminar participants at Arizona State University, Harvard University, and Rice University.
Financial Statement Analysis of Leverage and How It Informs
About Profitability and Price-to-Book Ratios
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-tobook ratios.

Keywords: financing leverage; operating liability leverage; rate of return on equity; price-to-book ratio
Data Availability: data is available from sources indicated in the paper 1
Financial Statement Analysis of Leverage and How It Informs
About Profitability and Price-to-Book Ratios
Leverage is traditionally viewed as arising from financing activities: firms borrow to raise cash for operations. This paper shows that, for the purposes of profitability analysis and equity valuation, two types of leverage are relevant, one indeed from financing activities but another from operating activities. Financial statement analysis that distinguishes the two types of leverage explains differences in shareholder profitability and the prices at which firms trade over their book values. The standard measure of leverage is total liabilities to equity. However, while some liabilities -- like bank loans and bonds issued – are due to financing, other liabilities -- like trade payables, deferred revenues, and pension liabilities -- result from transactions with customers and suppliers in conducting operations. Financing liabilities are typically traded in well-functioning capital markets where issuers are price takers. In contrast, firms are viewed as being able to add value in operations because operations involve trading in (input and output) product markets that are less perfect than capital markets. So there are a priori reasons for viewing operating liabilities differently from liabilities that arises in financing.

Our research asks whether a dollar of operating liabilities on the balance sheet is priced differently from a dollar of financing liabilities. As operating and financing liabilities are components of the book value of equity, the question is whether price-tobook ratios depend on the composition of book values. The price-to-book ratio is determined by the expected rate of return on the book value so, if components of book value command a different price premium, they must imply differential expected rates of 2

return on book value. Accordingly the paper also investigates whether the two types of liabilities are associated with differences in future book rates of return. To develop the specifications for the empirical analysis, the paper presents a financial statement analysis that...
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