Off-Balance-Sheet Assets, Financial Leverage, and Expected Stock Returns

This paper examines the cross-sectional relation between leverage and future stock returns. Prior research documents a puzzling negative correlation. We show that it is largely caused by firms' use of internal financing when having significant off-balance-sheet operating assets due to conservative accounting. Firms with high cost of external equity financing thus can have low leverage, creating a negative correlation between leverage and stock returns. In particular, firms with no debt contribute significantly to this phenomenon