Suppose AOL Time Warner, Inc. is having a bad year in 2011, as the company has incurred a $4.9 billion net loss. The loss has pushed most of the return measures into the negative column and the current ratio dropped below 1.0. The company's debt ratio is still only 0.27. Assume top management of AOL Time Warner is pondering ways to improve the company's ratios. In particular, management is considering the following transactions:
Sell of the cable television segment of the business for $30 million (receiving half in cash and half in the form of a long-term not receivable.) Book value of the cable television business is $27 million.
Borrow $100 million on long-term debt.
Purchase treasury stock for $500 million cash.
Write off one-fourth of goodwill carried on the books at $128 million.
Sell advertising at the normal gross profit of 60%. The advertisements run immediately.
Top management wants to know the effects of these transactions (increase, decrease, or no effect) on the following ratios of AOL Time Warner:
Current ratio
Debt ratio
Times-interest-earned ratio
Return on Equitya
Book value per share of common stock
Some of these transactions have an immediately positive effect on the company's financial condition. Some are definitely negative. Others have an effect that cannot be judged as clearly positive or negative. Evaluate each transaction's effect as positive, negative or unclear. Challenge your classmates on their assessments.