Valuation of goodwill

Meaning
• According to SSAP-22, UK Accounting Standard on Accounting for Goodwill,
“Goodwill is the difference between the value of a business as a whole and the aggregate of the
fair values of its separable net assets.”
Valuation of Goodwill
• The term “goodwill” is most widely used in business world but no one is able to define this term in crystal
clear words.

• It is considered as an invaluable asset – intangible in nature but it is not fictitious asset.

• In simple words, a business firm which earn reputation over a period of time gets the credit of goodwill that
means if a firm is a profitable one it is valued high and in turn attracts goodwill. Hence the reputation of a
firm coupled with its going profitability represents “goodwill”.

• Goodwill can be realizable or quantified in money’s worth when the firm get disposed of.
• From above points we can defined the goodwill as “ The capacity of a business to earn profits in future is
basically what is mean by the term ‘goodwill’”.

• It is present value of a firm’s anticipated excess earnings”.

 Meaning and need for valuation
• The need for the valuation of the goodwill is depends upon form of the organisation such as
1. sole proprietorship
2. Partnership firm
3. Joint stock companies

1. In case of sole proprietorship:

I. In this case it is valued at the time of disposal of the business. Goodwill cannot be
II. sold as a separate item.

2. In case of partnership firm:

The need for valuation of goodwill arises on some important events such as
I. Admission of a new partner
II. Retirement or death of a partner
III. Change in profit sharing ratio
IV. Dissolution or sale to a company
3. In case of joint stock companies:

The need for the valuation of goodwill arises in the following circumstances:

 When amalgamation of companies occur.

 When one company takes over the another or when the business of one company is sold to
another company.

 When a company wants to write off or reduce its debit balance in the profit and loss account.

 When a company wants to exercise controlling interest in another company.

 For the valuation of shares in the absence of stock exchange quotations.

 When conversion of shares from one class to another class takes place.

 When the government takes over the company’s business.

• Factors affecting the value of goodwill:

 The foremost factor that affects the goodwill is “profit”. The position over

 the past years and the expected to earn in future are important factor.

 Capital employed to earn profit.

 The yield expected by the investors.

 Customer associated with the business concern-personal approach.

 Market shares for its product.

 Quality of the service rendered.

 The position of a particular concern with respect to its competitors in the field.

 Technical innovations and tax planning.

 Relationship between management and staffs, or with the statutory bodies and government agencies.
Components of goodwill :
The most important component of goodwill are
• Profitability
• Normal rate of return (yield expected by investors)
• Capital employed

 PROFITABILITY:

•As we know profit is a measure component for goodwill as its depends upon the future profit of a firm. Its
natural that the buyers is keen to assess whether the firm will enhance the profitability in coming years. The
process of assessment whether the firm will maintain its profits in the future is otherwise called as “future
maintainable profits”.
•The factors which are considered while estimating the future maintainable profits :
1. Included factor : normal working expenses(depreciation and fixed asset ,interest at
debenture), appreciation in current assets, non-recurring expenses
2. Excluded factor : appreciation in fixed assets, transfer to general reserve, preference
dividends
3. Other factor: provision for tax, income from non-trading assets, average profits from
past years.
 Normal rate of return: It is natural that any investors wants a fair return on their investment which
is known as ‘ rate of earning’. It varies from industry to industry and depends upon various factor
such as bank rate , nature of industry , risk etc. It consist following elements:
1. Return at zero risk level: It refers to safe investment with no risk in which may be rate
of return is not high. It is also referred as “pure interest”.

2. Premium for business: It refers as risky investment. A margin is allowed to cover

ordinary risk in business. Profit will vary in proportion to risk covered in the industry.
The more is the risk ,the higher will be the rate of return.

3. Premium for financial risk: It refers to the risk connected with the capital structure.
Here margin is allowed to cover the risk connected with finances of business organ-
ization. A business firm with high debt ratio in the capital structure is considered to
be more risky.

 Capital employed: The quantum of profits earned with respect to the capital used is an
important basis for the valuation of goodwill.
• Of late capital employed represents the fixed asset with net working capital or also as an
aggregate of share capital, reserves, long-term loan.
• In other words , this term represents equity shareholders funds along with long- term
borrowings.
• The items involved in the determination of capital employed are:

1.Included items: All fixed assets less depreciation written off , trade investment, all
current assets
2. Excluded items: long term liabilities, all current liabilities, intangible assets including
goodwill, non-trading assets, fictitious assets
Methods of Valuation
The following are the methods of Valuation of Goodwill:
1. Average profit method
2. Super profit method
3. Annuity method
4. Capitalization method
1. Average Profit Method
It is presumed that any new business will not be able to earn profit during first few years.
Goodwill calculated by Multiplying past average profit by the number of years during which the expected profit
will accrue.
Goodwill is paid for obtaining a future advantage.

Formula:

Goodwill = Average Profit * Number of years purchase

 2. Super Profit Method
• Method emphasizes the valuation of goodwill on the basis of excess profit.
• Thought says that “Buyers real benefit lies not in total profits but in excess profit”

Super profit = Average Profit – Normal Profit

Goodwill = Super Profit * Number of Years
Normal profit = Capital Employed * Normal Rate of Return

Calculation of goodwill under Super normal Profit

Step 1: Average profit is calculated
Step 2: Normal Profit on the capital employed on basis of normal Rate of return calculated.
Step 3: Normal Profit is deducted from average profit
Step 4: Goodwill = Super profit * No. of years Purchase
3. Annuity Method
• Goodwill is determined as the present value of the future super profit.
So, Goodwill = Super Profit * Present value Factor (PVF)
• Present Value Factor cab be obtained either by annuity table or by formula
1
1−
(1+𝑖)𝑛
, where i = r/100
𝑖
• Steps involved
1. Future Super profit has to be calculated.
2. Rate of return has to be fixed
3. Present Value factors have to be calculated either by formula or annuity table.
4. Multiply the super Profit with PVF to find present value of super profit.
5. Aggregate of product of PVF and Super Profit is the value of Goodwill.
 4. Capitalization Method
• Goodwill can be calculated in Two ways in this method:
1. Capitalizing the average profit
2. Capitalizing the Super Profit
4.1 Capitalizing the average profit

• The valuation of goodwill is determined by deducting the actual capital employed in the business from the
capitalized value of the average profits on the basis of normal rate of return.

Steps involved:
Step 1: Ascertain the Average Profit
Step 2: Capitalize the Average Profit on the basis of Normal Rate of Return by using formula
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑓𝑖𝑡𝑠
Formula: 𝑁𝑜𝑟𝑚𝑎𝑙 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛

Step 3: Calculate Capital employed by deducting outside liability from Total assets
(excluding goodwill)
Step 4: Goodwill is obtained by deducting capital employed from capitalized average profit.
(Step2 – Step3)
4.2 Capitalizing the Super profit

• Under this method, Goodwill is calculated by capitalizing the super profits directly.
• Goodwill = Super Profits x (100/ Normal Rate of Return)

• Steps involved
Step-1: Capital Employed in the business is calculated as follows
Capital Employed= Total Assets- Outside Liabilities.

Step-2: Required profit on Capital Employed is calculated as follows

Required Profit =Capital Employed* required rate of return

Step-3: Average Profits for last few years is to be calculated

Step-4: Super Profit= Required Profits- Average Profits [Step 2 - Step 3]
Step-5: Goodwill = Super Profits * Required Rate of Return