Calculation of goodwill

Goodwill is the value of the reputation
of a firm in respect of profits in future
over and above the normal profits. The
excess profit earned over and above what
other firms are earning is called super
profit. Thus goodwill really arises only if the
firm is able to earn super profit. Goodwill is
an invisible and intangible asset.

FACTOR AFFECTING THE VALUE OF GOODWILL
1. Location : A favorable location of business helps
to a great extent in attracting customers. It increases
the profitability and also the value of goodwill.
2. Nature of Business : A business dealing in goods
having a stable demand is able to earn more profits
and therefore has more goodwill.
3.Efficiency of management ; A business managed
by persons of high integrity and efficiency enjoys
the advantage of high productivity and cost
efficiency. This leads to higher profits and greater
goodwill.

FACTOR AFFECTING THE VALUE OF GOODWILL ……………
4. Time Factor : A business concern running profitably for a
longer period will have more goodwill, since it is better
known to the customers.
5. Market situation : The monopoly condition on limited
competitions enables the business to earn more profits and
so the value of goodwill also be high.
6. Special Advantages : A firm which enjoys special
advantages like import license, low rate and assured
supply of electricity, long term contracts for supply of raw
materials , patents, trademarks , marketing tie-up with
government, etc., has higher value of goodwill.

NEED FOR VALUATION OF GOODWILL
The need for valuation of goodwill arises
under the following circumstances ;
 Admission of a partner.
 Retirement of a partner.
 Death of a partner.
 Dissolution of a firm or sale of partnership
business.
 Amalgamation of firms.
 Change in the profit sharing ratio of
existing partners.

METHODS OF VALUATION OF GOODWILL
Usually the method of valuing goodwill will be
mentioned in the partnership deed. The following
are the different methods of calculation of goodwill
used in partnership firms.
 Average profit method
 Weighted average profit method
 Super profit method
 Capitalization method – a) Capitalisation of
average profits & b) Capitalisation of Super
profit.
 Present value Super profits.

1. AVERAGE PROFITS METHOD
Under this method, the goodwill is valued at
agreed number of 'years' purchase of the average
profits of the past few years. It is based on the
assumption that a new business will not be able to
earn any profits during the first few years of its
operations. Hence, the person who purchases a
running business must pay in the form of goodwill a
sum which is equal to the profits he is likely to
receive for the first few years. The goodwill,
therefore, should be calculated by multiplying the
past average profits by the number of years during
which the anticipated profits are expected to
accrue.

ILLUSTRATION
The profit for the last five years of a
firm were as follows year 1999 Rs.
4,00,000; year 2000 Rs. 3,98,000;
year 2001 Rs. 4,50,000; year 2002 Rs.
4,45,000 and year 2003 Rs. 5,00,000.
Calculate goodwill of the firm on the basis
of 4 years purchase of 5 years average
profits.

SOLUTION
Average Profit =Total profit of last 5 years =
No. of years
=21,93,000
5
= Rs.4,38,600
Goodwill = Average Profits × No. of years
purchased
= Rs. 4,38,600 × 4
= Rs. 17,54,400

ILLUSTRATION
Calculate the amount of goodwill at
three years purchase of the last five years’
average profit . the firm earned profits
during the first 3 years as Rs.25000, Rs.
20000 and Rs.27000 and suffered losses
of Rs.12000 and Rs.7000 in the fourth
and fifth year.

SOLUTION
Average Profit =Total profit of last 5 years
No. of years
= 25000+20000+27000-12000-7000
5
= Rs.10600
Goodwill = Average Profits × No. of years
purchased
= Rs. 10600 × 3 = Rs. 31800

ILLUSTRATION
The following were the profits of a firm for the last three years.
Year ending Profit (Rs.)
March 31
2000 4,00,000 (including an abnormal gain of Rs.50,000)
2001 5,00,000 (after charging an abnormal loss of Rs. 1,00,000)
2002 4,50,000 (excluding Rs. 50,000 payable on the insurance
of plant and machinery )
Calculate the value of firm's goodwill on the basis of two years
purchase of the average profits for the last three years.

SOLUTION
Year Ended Profit [Rs.]
2000 (4,00,000 – 50,000)
2001 (5,00,000 + 1,00,000)
2002 (4,50,000 – 50,000)
3,50,000
6,00,000
4,00,000
Total 13,50,000
Solution
Average Profit = Rs.13,50,000
3
= Rs.450000
Goodwill = Average Profits × No. of years purchased
= Rs. 450000 × 2 = Rs. 900000

2. WEIGHTED AVERAGE PROFIT METHOD
This method is a modified version of the earlier
method. Under this method each year's profit is
multiplied by the respective number of weights i.e.
1,2,3,4 etc., in order to find out value of product and
the total of products is then divided by the total of
weights in order to ascertain the weighted average
profits. Thereafter, the weighted average profit is
multiplied by the agreed number to find out the value
of goodwill.
Weighted Average Profit = Total of Products of Profits
Total of Weights
Goodwill = Weighted Average Profits × Agreed Number
of years'(Purchase)

ILLUSTRATION
The profits of a firm for the year ended 31st
March for the last five years were as follows :
Year Profit (Rs.)
2009 19,000
2010 23,000
2011 30,000
2012 22,000
2013 18,000
Calculate the value of goodwill on the basis of
three years' purchase of weighted average profits after
weights 1,2,3,4 and 5 respectively to the profits for
2009, 2010, 2011, 2012 and 2013.

Solution
Year Profit Weight Product
2009
2010
2011
2012
2013
19000
23000
30000
22000
18000
1
2
3
4
5
19000
46000
90000
88000
90000
Total 15 333000
Weighted Average Profit = 333000 = 22200
15
Goodwill = 22200 × 3 = 66600

3. SUPER PROFITS METHOD
The excess of actual profits over the
normal profits is termed as super profits.
Normal profit on capital is ascertained by
multiplying the capital employed with the
normal rate of return in similar firms. The
value of goodwill under this method is
ascertained by multiplying the super profit
with certain number of years of purchase. The
steps involved in the calculation of the value of
goodwill under this method are ;

STEPS INVOLVED IN SUPER PROFITS METHOD
a) Calculate the average profit.
b) Ascertain the normal profit on the capital
employed
Normal profit = Capital employed × Normal Rate
100
c) Calculate the super profit by deducing
normal profit from the average profit.
d) Calculate goodwill by multiplying the super
profit by the decided number of years.

ILLUSTRATION
The books of business showed that the
capital employed on December
31,2001,Rs.5,00,000 and the profits for
the last five years were: 1997-Rs. 40,000;
1998- Rs. 50,000; 1999-Rs. 55,000;
2000-Rs. 70,000 and 2001-Rs. 85,000.
You are required to find out the value of
goodwill based on 3 years purchase of the
super profits of the business, given that the
normal rate of return is 10%.

SOLUTION
Normal Profit = Capital Employed × Normal Rate of Return
100
= 5,00,000 ×10
100
= Rs. 50,000
Average Profit = 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

4. CAPITALIZATION METHOD
Under this method the goodwill can be
calculated in two ways :
(a) by capitalizing the average profits, or
(b) by capitalizing the super profits.

(A) CAPITALIZATION OF AVERAGE PROFIT
In this method, the value of goodwill is
ascertained by deducting the actual capital
employed (net assets) in the business from
the capitalized value of the average profits
on the basis of normal rate of return. This
involves the following steps :

STEPS UNDER CAPITALIZATION OF
AVERAGE PROFIT
(i) Ascertain the average profits based on the past
few years' performance.
(ii) Capitalize the average profits on the basis of the
normal rate of return as follows :
Average Profits × 100/Normal Rate of Return
This will give the total value of business.
(iii) Ascertain the actual capital employed (net assets)
by deducting outside liabilities from the total assets
(excluding goodwill).
Capital Employed = Total Assets (excluding goodwill)
– outside liabilities
(iv) Compute the value of goodwill by deducting net
assets from the total value of business, i.e. (ii) – (iii).

ILLUSTRATION
A business has earned average profits
of Rs. 1,00,000 during the last few years
and the normal rate of return in a similar
type of business is 10%.Ascertain the value
of goodwill by capitalization method, given
that the value of net assets of the business
is Rs. 8,20,000.

SOLUTION
Capitalized Value of
Average Profits = 100000 × 100
10
= Rs 10,00,000
Goodwill = Capitalized Value – Net Assets
= 10,00,000 – 8,20,000
= Rs. 1,80,000

(B) CAPITALIZATION OF SUPER PROFITS
Under this method following steps are involved :
(i) Calculate Capital employed of the firm, which is equal to total assets minus outside
liabilities.
(ii) Calculate required profit on capital employed by using the following formula :
Profit = Capital Employed × Required Rate of Return/100
(iii) Calculate average profit of past years, that is, 3 to 5 years.
(iv) Calculate super profits by deducting required profits from average profits.
(v) Multiply the super profits by the required rate of return multiplier, that is,
Goodwill = Super Profits × 100/Normal Rate of Return

ILLUSTRATION
Following relates to the profit earned
by a firm for the last four year; Rs.15000,
Rs.25000, Rs.65000 and Rs.75000. the
total assets of the firm are Rs.640000and
outside liabilities Rs.140000. normal rate
of return is 6%. Calculate goodwill of the
firm under capitalization of super profit
method.

SOLUTION
Average Profit = 15000+25000+65000+75000
4
= 45000
Capital Employed = Total Assets – Outside Liabilities
= 640000 – 140000 = 500000
Normal profit on
Capital Employed = 500000 × 6/100 = 30000
Super Profit = 45000 – 30000 = 15000
Goodwill = 15000 × 100 / 6 = 250000

5. PRESENT VALUE OF SUPER PROFITS
Under this method, goodwill is estimated as the present
value of the future super profits. This requires following steps
(i) Calculate the future super profits for next 5 to 7 years
depending upon the business potential.
(ii) Choose the required rate of return.
(iii) Calculate present value factors.
(iv) Multiply present value factors with future super profits.
(v) The sum of product of present value factors and super
profits is the value of goodwill.

SOLUTION
Year I II III IV V
Profit
Normal Profit
Super Profit
PVF
Present Value
of Super Profits
100000
80000
20000
0.9091
18,182
120000
80000
40000
0.8264
33,056
90000
80000
10000
0.7513
7,513
100000
80000
20000
0.6830
13,660
150000
80000
70000
0.6209
43,463
Value of Goodwill = Rs. 18,182 + 33,056 + 7,513
+ 13,660 + 43,463
= Rs. 1,15,874

Calculation of goodwill

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