The Predictive Ability of Corporate Profitability Components and Future Earnings (Published)
Firms employing additional debt finance often do so with the expectations that future profits will more than compensate for the fixed cost of borrowing. Similarly additional investment of equity capital indicates management confidence that the future profitability of the firm will be greater than the fixed operating cost. Therefore the mapping of financing, investing and operating decisions to current earnings provides a more rounded view of likely future earnings. Following the decomposition of return on equity into financing, investing and operating leverages components by Agburuga & Ibanichuka (2016), we explore the ability of these components of corporate profitability to predict future earnings. We found that future earnings (FTE) was negatively related to financing leverage component (FLC) and investing leverage component (ILC) and positively related to operating leverage component (OLC). This study thus provides evidence consistent with the trade-off theory. The negative relation of FLC and ILC and positive relation of OLC respectively to future earnings is analogous to and systematically explains the negative and positive relations of accrual and cash flow components of earnings to future earnings and stock prices contrary to the Bernard & Stober (1989) finding that it is not systematic.
Keywords: Financing, investing and operating leverages components; accrual and cash flow components; return on equity