Before we start with the valuation of goodwill, let us briefly revise the concept of goodwill.
Goodwill is primarily an intangible asset that is related to the purchase of one company by another. The concept covers such portion of the purchase price, which is higher than the total of the net fair value of the assets that have been bought.
The importance of goodwill may be understood by its importance for increasing the business value. It is also instrumental in acquiring more customers. In common parlance, the goodwill of a company is understood to be its proven track record.
There are a whole host of factors that influence the goodwill of a company. Such factors are more likely to include the capital requirement nature of business, market situation, reputation of owners and profit trends, among others.
An example of goodwill – When company X purchases company Y for greater than the fair value of company X’s debts and assets, the amount that remains is recorded as goodwill in the balance sheet of company X.
Now that we have revised our knowledge of goodwill let us move on to the methods of valuation of goodwill.
Valuation of Goodwill
The valuation of goodwill essentially means that the calculation of these intangible assets is used to determine the remaining value of a company in the event it is purchased. The valuation of business takes into account different parameters such as the reputation of its owners, efficiency in the management, situation in the market, and special advantage if any.
The need for valuation of goodwill arises from a range of different scenarios –
In Partnership – If partners retire, expire, or is newly admitted, there is a need for goodwill valuation. It also becomes important in case of alterations in profit-sharing ratio or amalgamation.
In Company – In the instance of amalgamation of company or acquiring controlling interest, another would require goodwill valuation.
In Sole Proprietorship – Purchase considerations of selling off business are some of the situations where valuation of goodwill is needed.
Methods for Valuation of Goodwill
A company adopts the valuation method consistent with the market practices of the trade and the position maintained by it. The different methods of valuation of goodwill are mentioned below.
Average Profits Method
The average profits method primarily takes the following two forms -
Here, the goodwill is evaluated by the calculation of average profit against the number of years purchase.
This method is usually used in the instances of alterations of profit while also focusing on the current year’s profit. It calculates the previous year’s profit for obtaining the valuation.
Super Profits Method
The super profit method of valuation of goodwill covers the excess of the maintainable profits in the future as opposed to the normal profits. The formula is indicated below.
[Super profit = Average / Actual profit – Normal profit
Normal profit = (Capital employed X Normal rate of return) / 100]
The super-profits method can be undertaken by either of the two following methods.
Annuity Method of Goodwill
Annuity method in valuation of goodwill uses the average super profit over a specific number of years. The current value of an annuity is found on the basis of a discounted amount of super profit at the established rate of interest.
Purchase Method by Number-of-Years
Super profits in a definite number of purchase years are evaluated for establishing goodwill.
In goodwill capitalisation method, there are two ways in which the calculation can be done.
Average Profits Method
The calculation covers deduction of its actual capital that has been employed from the average profits of the capitalised value. It is undertaken based on the normal rate of return.
[Capitalised average profits = Average profits X 100 / Normal rate of return
Actual capital employed = Total assets (excluding goodwill) – Outside liabilities]
Super Profits Method of Valuation of Goodwill
In these methods, super profits are directly capitalised for the valuation of goodwill.
Test your skill –
Question: Kumar & Sons, Pvt. Ltd. has an average profit of Rs. 60,000. The capital is Rs. 4,00,000 and the business's normal rate of return have been found to be 10%. Calculate the goodwill value by capitalisation method of the goodwill of the super-profits method.
[To know the answer, refer to the solution given at the end of the article]
If you want to know more about different valuation methods of goodwill, refer to the online articles that are available over Vedantu’s platform. Do not forget to install the app on your device!
1. What is the Importance of Goodwill?
An intangible asset, goodwill, is connected with the purchase of one firm by the other. It relates to such part of the purchase price that is greater than the aggregate of the net fair value of the purchased assets.
It helps in enhancing the value of the business as well as acquire a greater customer base. It also includes a reputation that indicates an established track record of the company.
2. How to Calculate Goodwill?
The calculation of goodwill takes into account the parameters of the fair value of liabilities and the fair value of assets of the business that has been acquired. The derived sum is then further added to the fair value of the liabilities and assets of the purchasing business. The formula is –
Goodwill = Number of years X Average profits
Normal profit = Capital employed X Normal rate of return / 100
= 4,00,000 X 10 / 100 (Putting the values)
Super profit = Average profit – Normal profit
= 60,000 – 40,000 (Putting the values)
Goodwill = Super profits X 100 / Normal rate of return
=20,000 X 100 / 10
= 2,00,000 (Answer)