VALUATION OF GOODWILL
GOODWILL
A well-established firm earns a good name in the market, builds trust
with the customers and also has more business connections as compared
to a newly set up business. Thus, the monetary value of this advantage
that a buyer is ready to pay is termed as Goodwill. The buyer who pays
for Goodwill expects that he will be able to earn super profits as
compared to the profits earned by the other firms. Thus, goodwill exists
only in the case of firms making super profits and not in the case of
firms earning normal profits or losses.
Cont….
Goodwill is recorded in the books only when some consideration in money or money‟s worth is paid for it.
Thus, in the context of a partnership firm, the need for valuation of goodwill arises at the time of:
1. Change in the profit sharing ratio amongst the existing partners
2. Admission of a new partner
3. The retirement of a partner
4. Death of a partner
5. Dissolution of a firm where business is sold as going concern.
6. Amalgamation of partnership firms
Factors Affecting the Value of Goodwill
Nature of business: A firm that deals with good quality products or has
stable demand for its product is able to earn more profits and therefore
has more value.
Location of business: A business which is located in the main market or
at a place where there is more customer traffic tends to earn more profit
and also more goodwill.
Owner’s reputation: An owner, who has a good personal reputation in
the market, is honest and trustworthy attracts more customers to the
business and makes more profits and also goodwill .
Contd….
Efficient management: An organization with efficient management has
high productivity and cost efficiency. This gives it increased profits and
also high goodwill.
Market situation: The organization having a monopoly right or condition
in the market or having limited competition, enables it to earn high profits
which in turn leads to higher value of goodwill.
Special advantages: A firm that has special advantages like import
licenses, patents, trademarks, copyrights, assured a supply of electricity at
low rates, subsidies for being situated in a special economic zones (SEZs),
etc. possess a higher value of goodwill.
Methods of Valuation of Goodwill
The choice of the method of goodwill valuation depends entirely on the partners or the partnership deed when
they have made it.
1. Average Profits Method
i] Simple Average: Under this method, the goodwill is valued at the agreed number of years‟ of purchase of the
average profits of the past years.
Goodwill = Average Profit x No. of years‟ of purchase
ii] Weighted Average: Under this method, the goodwill is valued at an agreed number of years‟ of purchase of
the weighted average profits of the past years. We use the weighted average when there exists an increasing or
decreasing trend in the profits giving the highest weight to the current year‟s profit.
Goodwill = Weighted Average Profit x No. of years‟ of purchase
Weighted Average Profit = Sum of Profits multiplied by weights/ Sum of weights
Capitalization Method
(i) Capitalization of Average Profits: Under this method, the
value of goodwill is calculated by deducting the actual capital
employed from the capitalized value of the average profits on the
basis of the normal rate of return.
• Goodwill = Normal Capital – Actual Capital Employed
• Normal Capital or Capitalized Average profits = Average Profits
x (100/Normal Rate of Return)
• Actual Capital Employed = Total Assets (excluding goodwill) –
Outside Liabilities
Contd….
(ii)Capitalization of Super Profits: Under this method,
Goodwill is calculated by capitalizing the super profits
directly.
• Goodwill = Super Profits x (100/ Normal Rate of
Return)
