Financial statement analysis of leverage and how it informs about profitability and price-to-book ratios: evidence from large UK companies
2007
Ghazaryan, A.
Whether the quality of a firm's reported earnings affects investors' ability to predict future earnings and returns is still a subject of much debate among accounting researchers. This dissertation undertakes 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. This dissertation used the valuation model described in to explore the possible links between accounting method choices and the ability of investors to use reported earnings to predict future earnings. The results demonstrate that prior researchers' assumptions regarding which accounting methods are generally conservative or liberal are reasonably accurate over large numbers of firms. 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 dissertation 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.
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