Goodwill

The term ‘goodwill’ is often heard in business circles and even in normal conversation between buyers and sellers at any local market. As students of commerce, you probably already know that it is an intangible asset. But, there are several other aspects that comprise goodwill meaning, the details of which are given below.

 

Defining Goodwill

Goodwill is an intangible asset that exists between two companies when one is in the process of buying the other. It may also exist between a business and consumer, but for the sake of simplicity in understanding goodwill meaning, only the former condition is chosen. When company ‘A’ is willing to purchase company ‘B’ at a sum greater than ‘B’s tangible assets, goodwill exists. Such assets will comprise various aspects including brand value, fair employee and customer relations, Intellectual Property and patents, among some others.

 

How is Goodwill Calculated?

The following is a common goodwill formula used for its calculation.

Goodwill = P - (A+L)

Where,

  • P represents the price of the company being acquired.

  • A represents the fair/justified asset value.

  • L represents the fair/justified liabilities outstanding.

 

Types of Goodwill

There are 2 types of goodwill which are commonly found in the world of business.

 

  1. Purchased Goodwill: When a company acquires another as a ‘going concern’ and pays a value including the latter’s total assets but barring its outstanding liabilities, it is declared as purchased goodwill.

 

  1. Inherent Goodwill: When a company purchases another but makes no distinction between the assets and liabilities, and yet pays a sum higher than the latter’s fair market price, it is a classic example of inherent goodwill.

 

Real-World Example of Goodwill

A classic example of nature of goodwill and how it affects businesses was observed in 2018 when the US telecom giant T-Mobile acquired Sprint. With the new entity to be named ‘New T-Mobile’ the deal was cleared only in late 2020 after regulatory wrangling. The S-4 filing revealed that as of March 31, 2018, the deal was valued at $35.85 billion.

 

Sprint’s total assets stood at a formidable $78.34 billion while its liabilities were $45.56 billion. A quick calculation shows that the difference between asset and liability values stood at $32.78 billion. Yet, T-Mobile was willing to offer $35.85 billion for the deal.

As per the formula mentioned above, Goodwill = P - (A+L):

 

  • The total goodwill for this specific example would be $35.85 billion minus $32.78 or $3.07 billion. This would be purchased goodwill.

 

In this real-world example of goodwill, its valuation was the result of Sprint’s years of clean record and excellent customer retention rates.

 

In case you are wondering what an S-4 filing is, use Vedantu’s online resources to gather more information. You can also take advantage of virtual classrooms on this and many other topics.

 

Why is the Valuation of Goodwill Needed?

There are several reasons for its valuation, whereby understanding the concept of goodwill is essential to grasping the requirement for its valuation.

  • If there is a disturbance between the profit sharing ratio of existing partners, goodwill has to be invoked.

  • When admitting a new partner or upon the retirement or death of an existing partner, goodwill calculation is needed.

  • If a business is dissolved and the enterprise is dissolved and sold, inherent goodwill is a must to achieve a higher-than-expected value.

  • If partnership firms are consolidating, a certain degree of goodwill helps.

 

What are the Factors that Affect Goodwill?

Here are some of the most important factors affecting goodwill.

  1. Product quality: If a company has a record of excellent production quality resulting in years of high sales, it will automatically acquire inherent goodwill.

  2. Location: The better the location of the business premises of an establishment, the greater its chances of attracting more customers. Likewise, a rise in goodwill value will also be seen.

  3. Management efficiency: When a company has seen years of resolute and committed management, its goodwill factor multiplies several times upwards.

  4. Efficient supply chain: Any company which has a very well-regulated supply chain will automatically have high levels of goodwill.

  5. Special or unique advantages: Imagine a company which owns a lot of patents, a variety of trademarks, carries a reputable brand image and has certain high-quality Intellectual Property Rights. Such a company will surely have better goodwill than its competitors who lack such value acquisitions.

  6. Other resources: When a company boasts a loyal customer base, superior after-sales service, effective advertisement campaigns, known brand ambassadors and export/import licenses, its goodwill factor multiplies many times.

 

What are the Methods of Goodwill Valuation?

There are 3 main methods used for the valuation of goodwill. They are:

  1. Capitalisation Method.

  2. Super Profits Method.

  3. Average Profits Method.

Note that these are only the primary elements comprising the goodwill meaning. To have a better-rounded idea of goodwill as an advanced student of commerce, you are encouraged to visit the other sections of Vedantu’s official website right away!

FAQ (Frequently Asked Questions)

A. What is Goodwill?

Goodwill is an intangible asset common in business circles valued especially when mergers and acquisitions take place. If a company has goodwill, it is more likely to have a greater selling price during an M&A process. A loyal client base, efficient management, superb branding and effective advertising, among some other criteria, constitute goodwill meaning and its valuation for any company in the long run.

B. What Are The Types of Goodwill?

There are 2 main types defined as far as the essential features of goodwill are concerned: purchased and inherent. When a company (A) purchases another (B) by subtracting the latter’s liabilities from assets, it is a purchased goodwill. When another company (C) purchases yet another entity (D) but without distinguishing between the assets and liabilities, it is classified as inherent goodwill.

C. How Is Goodwill Calculated?

The common formula to calculate goodwill is the following:

Goodwill = P − (A+L)

Here,

  • P is the fair price of a company

  • A is the fair asset value

  • L is the fair value of liabilities outstanding of the company being bought.