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

TLDR: In this article, the authors present a financial statement analysis that distinguishes leverage that arises in financing activities from leverage arising in operations, and conclude that balance sheet line items for operating liabilities are priced differently than those dealing with financing liabilities.

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 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-to-book ratios.