Goodwill:- Goodwill is the value of reputation of a business firm in respect of profits that will earn in future over and above the normal profit.
Profits over and above the normal profit is termed as super profit. The excess profit may be due to locational advantage, better customer service, quality of goods sold to customers, reputation of the owner of the business and so on.
Goodwill is an intangible asset.
Example:- ABC wants to purchase business of XYZ and the net worth (assets-liabilities) is Rs.100000. ABC is ready to pay 110000 for it, the extra amount i.e. Rs. 10000 is known as goodwill. One of the reason to pay extra amount is capability of business to to earn more profit than normal profit.
Methods of Valuation of Goodwill:-
Average Profit Method:- According to this method, goodwill is valued at agreed number of years’ purchase of average profits.
Note-Average profits will be of last few year.
For averaging the past profit, either simple average or weighted average may be used.
Example- The profits of ABC partnership firm are Rs. 40000 , 30000, 42000, 38000 and 46000. Calculate the value of goodwill on the basis of 3 years’ purchase of the average profits of last 5 years.
Solution- Total profits of 5 years = Rs. (40000+30000+42000+38000+46000)=196000
Average profit will be sum of profits/No. of years
Average profit =Rs. 196000/5 = Rs. 39200
Three years’ purchase of the above mentioned average profit = Rs. 39200*3=Rs. 117600
Hence, value of goodwill = Rs. 117600 (Average profits * No. of years’ purchased).
The above example is based on simple average profits. If there exists an increasing on decreasing trend, then weightage average profits is to used. Weighted average based on specified weights like 1, 2, 3, 4 for respective year’s profit.
Example-
| Year | Profit |
| 2017-18 | 20000 |
| 2018-19 | 22000 |
| 2019-20 | 29000 |
| 2020-21 | 30000 |
| 2021-22 | 16000 |
Solution–
| Year | Profit | Weight | Product |
|---|---|---|---|
| 2017-18 | 20000 | 1 | 20000 |
| 2018-19 | 22000 | 2 | 44000 |
| 2019-20 | 29000 | 3 | 87000 |
| 2020-21 | 30000 | 4 | 120000 |
| 2021-22 | 16000 | 5 | 80000 |
| 15 | 351000 |
Weighted Average Profit = Rs. 351000/15 = Rs. 23,400
Goodwill = Rs. 23,400 × 3 = Rs. 70200
Super Profit Method:- According to this method, super profit (Actual profit(maintainable)-Normal profit)) is to taken into consideration for the valuation of goodwill (Super profit*No of years’ purchase).
Normal profit = Normal rate of return* Capital employed.
Example- ABC firm’s capital employed on 31st march 2022 is Rs. 500000 and profits for the last 5 years were 2017–Rs. 40,000: 2018-Rs. 50,000; 2019-Rs. 55,000; 2020- Rs.70,000 and 2021-Rs. 85,000. calculate goodwill based on 3 years purchase of the super profits of the business, given that the normal rate of return is 10%.
Solution- Normal Profits = Firm’s Capital Normal Rate of Return ×100
= Rs. 5,00,000*10/100× = Rs. 50,000
Average Profits:
| Year | Profit |
|---|---|
| 2017 | 40000 |
| 2018 | 50000 |
| 2019 | 55000 |
| 2020 | 70000 |
| 2021 | 85000 |
| Total | 300000 |
Average Profits = Rs. 3,00,000/5 = Rs. 60,000
Super Profit = Rs. 60,000 – Rs. 50,000 = Rs. 10,000
Goodwill = Rs. 10,000 × 3 = Rs. 30,000
Capitalization of super profit:-
In this method, the value of goodwill is calculated by capitalizing the super profit at the normal rate of return. It is calculated as:- Super profit x 100/Normal rate of return
Capitalization Method:-As per this method, the goodwill can be calculated in two ways:
(a) by capitalizing the average profits= Average Profits × 100/Normal Rate of Return
(b) by capitalizing the super profits =
Goodwill =capitalized value of average profits -Net Assets
Net Assets= Total Assets (excluding goodwill) – Outside Liabilities