Before we jump in the concept of valuation of Goodwill, let us first understand the meaning of term “Goodwill”. Goodwill is an Intangible asset of the business. As the definition of Intangible asset, Goodwill cannot be seen or felt. In simple words it is business’s worth or its reputation earned oveRead more
Before we jump in the concept of valuation of Goodwill, let us first understand the meaning of term “Goodwill”.
Goodwill is an Intangible asset of the business. As the definition of Intangible asset, Goodwill cannot be seen or felt. In simple words it is business’s worth or its reputation earned over a period of time.
Calculation of value of the goodwill in monetary terms is done at the time of merger or acquisition of the business. Goodwill is often applied to businesses which are earning large number of profits, have crucial corporate links and large customer/client base.
Self-earned goodwill is never shown in monetary terms in business’s own balance sheet while goodwill which is purchased is shown in the asset side of the balance sheet of the buyer business.
Following are the methods under which goodwill can be valued:
- Average Profit Method – In this method, Goodwill is calculated by average profits multiplied by the number of years purchased. Typically, last 5-6 years profit figures are taken ignoring any abnormal gains or loss during the year. Formula for the same would be as follows:
Goodwill = Average Profit x No. of Years Purchase
- Weighted Average Method – This method is updated method of average profit method, Profits of the previous years are calculated by specific number of weights. This method is useful when there is a lot of fluctuations in the profits and importance has to be given to current year’s profit. Formula for the same would be as follows:
Goodwill = Weighted Average Profit x No. of Years Purchase
Where,
Weighted Average Profit = Sum of Profits multiplied by weights / Sum of Weights
- Super Profit Method – Super profit is additional profit generated by the business over normal profit. Further for the calculation, Super profit is capitalized by the normal rate of return and resulting figure is value of Goodwill.
Formula for the same would be as follows:
Goodwill = Super Profits x (100/Normal Rate of Return)
- Annuity Method – In this method, Discounted amount of the super profits is calculated by taking into consideration the current value of the annuity at rate of return.
Formula for the same would be as follows:
Goodwill = Super Profit x Discounting Factor
- Capitalization Method – In this method, existing capital employed is deducted from capitalized number of average profits or super profits. The resulting figure is Goodwill.
Formula for the same would be as follows:
a. Average Profit Capitalization Method –
Goodwill = [Average Profit / Normal Rate of Return x 100] – Capital Employed
b. Super Profit Capitalization Method –
Goodwill = Super Profits x (100/ Normal Rate of Return)
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Definition Goodwill is an intangible asset that places an enterprise in an advantageous position due to which the enterprise is able to earn higher profits without extra effort. For example, if the enterprise has rendered good services to its customers, it will be satisfied with the quality of its sRead more
Definition
Goodwill is an intangible asset that places an enterprise in an advantageous position due to which the enterprise is able to earn higher profits without extra effort.
For example, if the enterprise has rendered good services to its customers, it will be satisfied with the quality of its services, which will bring them back to the enterprise.
Features
The value of goodwill is a subjective assessment of the valuer.
• It helps in earning higher profits.
• It is an intangible asset.
• It is an attractive force that brings in customers to the business.
• It has realizable value when the business is sold out.
Need for goodwill valuation
The need for the valuation of goodwill arises in the following circumstances :
• When there is a change in profit sharing ratio.
• When a new partner is admitted.
• When partner retires or dies.
• When a partnership firm is sold as a going concern.
• When two or more firms amalgamate.
Classification of goodwill
Goodwill is classified into two categories:
• Purchased goodwill
• Self-generated goodwill
Purchased goodwill :
Is that goodwill acquired by the firm for consideration whether paid or kind?
For example: when a business is purchased and purchase consideration is more than the value of net assets the difference amount is the value of purchase goodwill.
Self-generated goodwill
It is that goodwill that is not purchased for consideration but is earned by the management’s efforts.
It is an internally generated goodwill that arises from a number of factors ( such as favorable location, efficient management, good quality of products, etc ) that a running business possesses due to which it is able to earn higher profits.
Methods of valuation
1. Average profit method
2. Super profit method
3. Capitalization method
Average profit method: goodwill under the average profit method can be calculated either by :
• Simple average profit method or
• Weighted average profit method
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