Goodwill is an intangible asset in a business records on the active part of its balance sheet. When a business it is sold this account takes the highest importance for the seller and buyer negotiation process. This account represents the premium a business pays for the acquired company’s intangible assets that can’t be specifically identified but that add value to its business. Such assets might include brand recognition and customer loyalty. Calculating goodwill is a process that requires your business to value an acquired company’s identifiable assets individually.
In essence the Goodwill is the difference between the value of a business enterprise as a whole and the sum of the current fair values of its identifiable tangible and intangible net assets. Net assets are the assets that are left after subtracting the company’s liabilities. To figure “net” identifiable assets, subtract the liabilities on the acquired company’s balance sheet from the fair value of its identifiable assets. Goodwill is only recorded when its amount is substantiated by an arm’s-length transaction. Goodwill cannot be sold or acquired separately but has to be included in a purchase with the net assets of a business enterprise. To consider an intangible asset that is absent from the balance sheet “identifiable,” it must originate from a contractual right or you must be able to sell it separately from the company. Such assets might include client contracts or patents.
The fair market value of an identifiable asset is the amount for which you could sell it on the open market to a willing buyer. For assets that have specific market quotes, such as stocks, the fair value is simply its current market price. For assets sold less frequently, such as inventory, a business might use the market price of a similar item sold by another business. For assets with limited or no market data, such as patents, a business might use a financial model to value the asset based on estimates of the future cash flows it will generate.
Choosing the correct valuation formula and applying it properly can be a daunting task and should be left to the auspices of an experienced professional. However, you can become familiar with the general guidelines of a widely used business valuation formula that will, at a minimum, give you an idea of what’s involved.
There are three methods of valuation of goodwill of the firm;
- Average Profits Method
- Super Profits Method
- Capitalization Method
Average Profits Method
Under this method Goodwill is calculated on the basis of the average of some agreed number of past years. The average is then multiplied by the agreed number of years. This is the simplest and the most commonly used method of the valuation of goodwill.
Goodwill = Average Profits X Number of years of business
Before calculating the average profits the following adjustments should be made in the profits of the firm:
- Any abnormal profits should be deducted from the net profits of that year.
- Any abnormal loss should be added back to the net profits of that year.
- Non-operating incomes e.g. income from investments etc. should be deducted from the net profits of that year.
Let’s explain this method with a simple example.
Antea shpk (simple company) agreed to buy the business of Edi (small business). Based in the information received by the accountants, who is presented below, in this process the Goodwill should be valued at three years purchase of Average Profits of last five years.
The profits of Antea shpk for the last five years are:
During this period the Antea shpk:
- In the year 2013 the company suffered a loss of 15,000 Lek due to fire in the factory.
- In the year 2016 the company earned an income from investments outside the business 4,500 Lek.
The estimation, based in the above facts consists on:
Total profits earned in the past five years = 10,000 + 15,000 – 3,000 + 9,000 + 11,000 = 42,000 Lek.
Total Profits after adjustments = 42,000 Lek + 15,000 Lek – 4,500 Lek = 52,500 Lek
Average Profits= 52,500 Lek / 5= 10,500 Lek
Goodwill = 10,500 Lek × 5 = 52,500 Lek
Super profits method
Super Profits are the profits earned above the normal profits. Under this method Goodwill is calculated on the basis of Super Profits i.e. the excess of actual profits over the average profits.
For example, if the normal rate of return in a particular type of business is 20% and your investment in the business is 1,000,000 Lek, then your normal profits should be 200,000 Lek. But if you earned a net profit of 230,000 Lek, then this excess of profits earned over the normal profits i.e. 230,000 Lek –200,000 Lek = 30,000 Lek are your super profits.
For calculating Goodwill, Super Profits are multiplied by the agreed number of years of purchase.
Steps for calculating Goodwill under this method are given below:
- i) Normal Profits = Capital Invested X Normal rate of return/100
- ii) Super Profits = Actual Profits – Normal Profits
iii) Goodwill = Super Profits x No. of years purchased
For example, the capital employed as shown by the books of Antea shpk is 50,000,000 Lek. And the normal rate of return is 10 %. Goodwill is to be calculated on the basis of 3 years puchase of super profits of the last four years. Profits for the last four years are:
Total profits for the last four years = 10,000,000 Lek + 12,250,000 Lek + 7,450,000 Lek + 5,400,000 Lek = 35,100,000 Lek
Average Profits = 35,100,000 Lek / 4 = 8,775,000 Lek
Normal Profits = 50,000,000 Lek X 10/100 = 5,000,000 Lek
Super Profits = Average/ Actual Profits – Normal Profits = 8,775,000 Lek – 5,000,000 Lek = 3,775,000 Lek
Goodwill = 3,775,000 Lek × 3 = 11,325,000 Lek
There are two ways of calculating Goodwill under this method:
(a) Capitalization of Average Profits Method
(b) Capitalization of Super Profits Method
Capitalization of Average Profits Method
Under this method we calculate the average profits and then assess the capital needed for earning such average profits on the basis of normal rate of return. Such capital is called capitalised value of average profits. The formula is:-
Capitalized Value of Average Profits = Average Profits X (100 / Normal Rate of Return)
Capital Employed = Assets – Liabilities
Goodwill = Capitalized Value of Average Profits – Capital Employed
For example a business earns 40,000 Lek as its average profits. The normal rate of return is 10%. Total assets of the firm are 1,000,000 Lek and its total external liabilities are 500,000 Lek.
To calculate the amount of goodwill:
Total capitalized value of the firm = 40,000 Lek × 100/10 = 400,000 Lek
Capital Employed = 1,000,000 Lek – 500,000 Lek = 500,000 Lek
Goodwill = 500,000 Lek – 400,000 Lek = 100,000 Lek
Capitalization of Super Profits
Under this method first of all we calculate the Super Profits and then calculate the capital needed for earning such super profits on the basis of normal rate of return. This Capital is the value of our Goodwill.
The formula is:
Goodwill = Super Profits X (100/ Normal Rate of Return)
For example Antea shpk earns a profit of 50,000 Lek by employing a capital of 200,000 Lek, The normal rate of return of a firm is 20%.
To calculate Goodwill:
Normal Profits = 200,000 Lek x 20/100 = 40,000 Lek
Super profits = 50,000 Lek – 40,000 Lek = 10,000 Lek
Goodwill = 10,000 Lek × 100 / 20 = 50,000 Lek
The methods of calculating Goodwill can all be used for determining the estimated monetary value of goodwill for making a purchase decision on a business, but the acceptance of the results from one to another method is part of negotiation process.