What is Goodwill And How to calculate Goodwill?

What is Goodwill

Goodwill means the ‘good name’ or the reputation earned by a firm through the hard work and honesty of its owners. If a firm renders good service to the customers, the customers who feel satisfied will come again and again and the firm will be able to earn more profits in the future.

Thus, goodwill is the value of the reputation of a firm which enables it to earn higher profits in comparison to the normal profits earned by other firms in the same trade.

The term goodwill is generally used to denote the benefit arising from connections and reputation.

Characteristics of Goodwill

1. It is an intangible asset: Goodwill belongs to the category of intangible assets such as patents, trademarks, copyrights, etc. It does not suffer wear and tear and as such, the question of depreciation does not arise on it, as in the case of other assets.

2. Its value is liable to constant fluctuations: While goodwill does not depreciate, its value is liable to constant fluctuations. It is always present as a silent asset in a business where there are super profits but declines in value with the decline in earnings.

3. It is valuable only when the entire business is sold: Goodwill cannot be sold in part. It can be sold with the entire business only. The only exception is at the time of admission and retirement of a partner.

4. It is difficult to place an exact value on goodwill: This is because its value may fluctuate from time to time due to changing circumstances that are internal and external to the business.

Factors Affecting the Value of Goodwill

  1. The favorable location of the business: If the business is located at a convenient or prominent place, it will attract more customers and therefore will have more goodwill.
  2. The efficiency of Management: If the business is run by experienced and efficient management, its profits will go on increasing, which results in an increase in the value of goodwill.
  3. Nature of Goods: If a business deals in goods of daily use, it will have steady profits as the demand for these goods will be stable. Such business will have more goodwill. But if it deals in fancy goods, its profits will be uncertain, and as such the value of the goodwill will be less.
  4. The trend of Profit: If the profits of a business are increasing continuously, the value of its goodwill will be more. If the profits are declining or if the profits are uncertain, the value of its goodwill will be less.

Methods of Valuation of Goodwill

There are three methods of valuing goodwill:

  1. Average Profit Method
  2. Super Profit Method
  3. Capitalisation Method

1. Average Profit Method

This is a very simple and widely followed method of valuation of goodwill. In this method, goodwill is calculated on the basis of the number of past year profits. The average of such profits is multiplied by the agreed number of years to find out the value of goodwill.

Value of goodwill=Average profit ×Number of years of purchased

Goodwill = Average profit × Number of year’s purchase

Numerical example

The following are the profits of a firm in the last five years:

2014: Rs.4000; 2015:Rs.3000; 2016: Rs.5000; 2017: Rs.4500; 2018: Rs.3500.

Calculate the value of goodwill at 3 years purchase of average profits of five years.

Solution

Goodwill = Average profit × Number of years of purchase

Average profit = Total profit / Number of years

                        = 4000+3000+5000+4500+3500/5

                        = 20,000 / 5

                        =Rs. 4000

Goodwill = Average profit × Number of years of purchase

               = 4000 × 3

                = 12,000

2. Super Profit Method

In this method Goodwill is calculated on the basis of surplus profit earned by other firms in comparison to average profits earned by other firms. If a business has no anticipated excess earnings, it will have no goodwill. Such excess profits are called super-profits and the goodwill is calculated on the basis of super-profits.

1.Normal profit = Capital invested × Normal rate of return / 100

2.Super Profit = Actual or Average profit – Normal profit

3.Goodwill = Super profit × No. of years purchased

Numerical example

A firm’s average profit is Rs.70,000. It includes an abnormal profit of Rs. 5000. Capital invested in the business is Rs. 5,50,000 and the normal rate of return is 10%. Calculate goodwill at four times the Super profit.

Solution

Actual Average Profit = Average profit – Abnormal profit

                                   = 70,000 – 5,000

                                   = 65,000

Normal Profit              = Capital Invested × Normal Rate of Return / 100

                                   = 5,50,000 × 10 / 100

                                   = Rs. 55,000

Super Profit                = Actual Average Profit – Normal Profit

                                   = 65,000 – 55000

                                   = Rs. 10,000

Goodwill                     = Super profit × Number of Years purchased

                                   = Rs. 10,000 × 4

                                   = Rs. 40,000.

3. Capitalisation Method

Under this method goodwill can be calculated in two ways:

  1. By Capitalising on the average profits
  2. By Capitalising on the super-profits

1.By Capitalizing of Average profits method

Under this method first of all we calculate the average profits and then we assess the capital needed for earning such average profits on the basis of the normal rate of return.

Capitalised value of Average profits = Average profits × 100 / Normal Rate of Return

Goodwill = Capitalised value of Average profits – Net Assets

2.Capitalisation of Super profit Method

Under this method first of all we calculate the super profit and then we assess the capital needed for earning such super profits on the basis of the normal rate of return.

Goodwill = Super profit × 100 / Normal Rate of Return

Numerical example

Calculate goodwill according to the Capitalization of Average Profits Method and Capitalization of Super Profit Method

Solution

  1. By Average Profits Method

Capitalized value of Average profits = Average Profits × 100 / Normal Rate of Return

                                                         = 72,000 × 100 / 10

                                                         = Rs. 7,20,000

Capital Employed = Assets – Liabilities

                             = 9,70,000 – 4,00,000

                             = 5,70,000.

Goodwill    = Capitalised value of Average Profits – Net Assets

                  = 7,20,000 – 5,70,000

                  = 1,50,000.

  • By Super Profit Method

Capital Employed = Assets – liabilities

                             = 9,70,000 – 4,00,000

                             = 5,70,000

Super Profit = Average Profit – Normal Profit

                    = 72,000 – 57,000 ( 10% of 5,70,000 )

                    = 15,000

Goodwill = Super Profit × 100 / Normal rate of return

               = 15,000 × 100 / 10

               = Rs.1,50,000.


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