Financial Analysis

«The Goodwill, the Bad and the Ugly» (The Economist)

1. Why should investors be wary of industries with a high ratio of goodwill to

assets?

Investors should be wary of industries with a high ratio of goodwill to assets because
goodwill cannot be used to raise cash and affords no asset protection (goodwill is
intangible).

Companies are required to test goodwill annually for impairment and impairment can
significantly affect a firm’s earnings. Optimistic expectations of an acquired company’s
future financial performance can lead to an increased risk of future goodwill
impairment, particularly during an economic downturn, which may have a significant
impact on earnings. The article says that “as the economy deteriorates and more firms
trade down towards (or even below) their book value, empire-builders are having to
mark down the value of assets”. Due to the economic crisis, there are a lot of write-
downs. For instance, in 2008, Time Warner had a $25 billion goodwill charge which
has pushed the company into an operating loss.

“Write-downs reduce overall book value and increase leverage ratios”. It can have an
effect on the share price. For instance, Regions Financial, an American bank, lost a
quarter of its value on January 20th after taking a $6 billion goodwill charge (on its
purchase of AmSouth Bancorp).

Finally, goodwill can also sap investor confidence less directly, “by raising awkward
questions about managers' competence”. Indeed, we can wonder whether it is always
reasonable to overpay for a company. So , a real question for investors is whether
goodwill represents real value for the acquired company or it is just a surplus paid
amount during the acquisition.

All these reasons explain why investors should be wary of industries with a high ratio
of goodwill to assets.

2. Why do industries such as health care, consumer goods and telecoms have a
high ratio of goodwill to total assets?

Industries such as health care, consumer goods and telecoms have many intangible
assets.

In the health care industry, they have high technology assets, such as databases, medical
records and patents.

In the consumer goods industry, the brand reputation is important, customer’s loyalty
and the relationship with distributers.

In the telecoms industry, they have high technology assets, such patents, software.
Moreover, these industries have little competitors and little substitutes. They have a
long-term relationship with customers and they invest a big amount of money in its
brand and public image.

All these intangible assets are difficult to be evaluated during an acquisition. As a result,
part of this “hidden value” is asked to be paid as goodwill by the acquiring company.
This results in a big amount of accumulated goodwill in the balance sheet of the
acquiring company.

3. Why does the impairment of goodwill have no effect on cash flow?

The impairment of goodwill has no effect on cash flow because it is not something that
a company pays. There is no cash transaction associated with the impairment of
goodwill. So, the impairment of goodwill cannot affect current or future cash flows and
it is not recorded on the Statement of Cash Flows.