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

As with most design development projects, one key challenge was how to select and organize the content of the notice to address these goals and questions. We used the information and elements required by the law, organizing them in different ways throughout the process to arrive at a final organization of the content that worked. We developed and tested a variety of designs, ultimately structuring the disclosure of information sharing practices in a table format. We learned that we needed to include an educational component in the notice as consumers had no prior understanding of information sharing practices. To do. | w 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@ Graduate School of Business Columbia University 3022 Broadway Uris Hall 604 New York NY 10027 STEPHEN H. PENMAN shp38@ 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 differences

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