Valuation of Goodwill
Valuation of Goodwill
Meaning of goodwill:
Goodwill is the extra value attached to the business over and above the intrinsic
value of its net assets. In other words it is the value of reputation or good name of
the business
Definition of goodwill:
Goodwill is defined as “the present value of a firm’s anticipated excess
earnings.”
Types of goodwill:
P.D. Leake has classified goodwill as under:
a) Dog-goodwill:
Dogs are attached to the persons and such customers lead to personal
goodwill which is not transferable.
b) Cat-goodwill:
Since Cats prefer the person of the old home, similarly such customers
give rise to locality goodwill.
c) Rat-goodwill:
The other variety of customer has attachment neither to the person nor to the
place, which in other words is known as fugitive goodwill.
Features of goodwill:
i. Goodwill is an intangible asset i.e., it cannot be seen or touched.
ii. Goodwill is a real asset but not a fictitious asset
iii. Goodwill always exist with business but it cannot exist by itself
iv. Goodwill is subject to fluctuations.
Factors determining the value of goodwill:
i. Location factors
ii. Time factor
iii. Nature of business
iv. Efficiency of management
v. Past profits of a business
vi. Stability of a business
vii. Future prospects of a business
viii. Other factors such as general economic conditions, political stability,
government policies, trade cycles etc
There are various circumstances when it may be necessary to value goodwill.
Some of the circumstances are:
a) In the case of a sole-trading concern
When a sole-trading concern is sold
When a sole-trading concern is converted into a partnership firm or a
joint stock company
When a sole-trading concern is amalgamated with another sole-
trading concern.
b) In the case of a Partnership firm
On the admission of a new partner
On the retirement of a partner
On the death of a partner
On the amalgamation of partnership firms
On the sale of partnership firm to a limited company
c) In the case of joint stock company
On the amalgamation of two or more companies
On the absorption of one company by another company
On the external reconstruction of a company
On the acquisition of majority of shares by a holding company
For the purpose of valuation of shares
Methods of valuation of goodwill:
a) Average profits method
b) Capitalization method
c) Super profit method
d) Annuity method
Average profits method:
Under this method, the value of goodwill is calculated by multiplying the
adjusted average annual profits by the number of years of purchase.
Value of goodwill= adjusted average annual profits * number of years of purchase
Steps for valuation of goodwill under average profit method:
Step -1: calculation of adjusted profits or adjusted future profits or maintainable
profits
Particulars Rs
Profit Xxx
Add: all expenses and losses not likely to occur or incur in Xxx
future.
( for example: extraordinary salary of a person, loss from fire or
theft(i.e abnormal losses) capital expenses etc
Add: all profits likely to come in the future
Xxx
For e.g profit due to new line of business
Xxx
Less: all expenses and losses expected to occur in future
For e.g salary of directors and staff to be appointed, insurance
on stock in future, depreciation in future, cost of management or
any expenses not provided earlier but to be incurred in future
Less: profit not likely to arise in future
Adjusted profit or future profits Xxx
xxxx
Note: when the future possibilities are not given in the problem, students have to
find out the average profits(step 2) directly.
Step -2: calculation of adjusted average profits
After ascertaining the adjusted profits, it is necessary to find out the adjusted
average profits. It can be ascertained by using any one of the following methods
a) Simple average profit method
b) Weighted average profit method
Simple average profit method:
When there is fluctuation in the profits, simple average profit method should be
followed. This can be calculated by using the following formulae:
Adjusted average profits(simple average) = total adjusted profits of all the given
years / no of years
Weighted average profit method:
When the weights for each year are given in the problem or when the profits are
following an increasing or decreasing trend, weighted average profit should be
calculated.
This can be calculated by multiplying each year’s profit with the weights
to find out the total product. Then the total product should be divided by total
weights to find out the weighted average profits
Weighted adjusted average profits= total product / total weights
Step -3: Calculation of goodwill:
Value of goodwill= adjusted average profits * no of years of purchase
Note : if the no of years of purchase is not given, then the number of years for
which profit or loss details are given, should be taken.
Problems :
1) Mr. Amar has been doing business, intends to sell his business on 1-3-2015.
From the following particulars ascertain the amount of goodwill based on 3
years purchase of average profits of last 4 years. The profits during 4 years
were as follows:
2021-22 Rs 2, 00,000
2022-23 Rs 2, 40,000
2023-24 Rs 3, 00,000
2024-25 Rs 3, 60,000
At the time of acquisition of business, the buyer was employed as a manager
of similar business on a salary of Rs 6000 per month. The profits of 2014-15
include income from investment of Rs 20,000. The profits of 2011-12 were
reduced by Rs 60,000 being loss on speculation. Similarly in 2013-14 profits
were reduced by Rs 1, 00,000 due to loss from betting.
2) Ramesh purchased a business from Suresh from 1-4-15. Profit earned by
Suresh for the preceding years were:
2022-23 Rs 5,00,000
2023-24 Rs 6,00,000
2024-25 Rs 5,40,000
It was found that the profits for the year 2012-13 included a non-recurring
income of Rs 20,000 and profits for the year 2014-15 was reduced by 30,000
due to an abnormal loss on account of a small fire in the shop. The
properties of the business were not insured in the past, but it was thought
prudent to insure the property in future at premium of Rs 5000 p.a. Ramesh
at the time of purchase of business was employee as manager of an identical
business concern at a monthly salary of Rs 10,000. He intends to replace the
manager of business who is drawing a salary of Rs 7500 p.m. the goodwill is
estimated at 2 years purchase of average profits. Calculate goodwill.
3) The following particulars are available in respect of the business carried on
by Mr. Madhu
a) Profits earned 2022-23 Rs 50,000
2023-24 Rs 48,000
2024-25 Rs 52,000
b) Profits of 2023-24 is reduced by Rs 5000 due to stock destroyed by fire
and profits of 2012-13 included a non- recurring income of Rs 3000
c) Profits of 2024-25 include Rs 2000 income on investment
d) The stock is not insured and it is thought prudent to insure the stock in
future. The insurance premium is estimated at Rs 500 p.a
e) Fair remuneration to the Proprietor (not taken in the calculation of
profits) is Rs 10,000 p.a. You are required to compute the value of
goodwill on the basis of 2 years purchase of average profits of the last
3 years.
4) The profits disclosed by Chaitra Ltd for the past 5 years were as follows:
2020-21 Rs 40,000 (including abnormal profit Rs 5000)
2021-22 Rs 50,000(after charging abnormal loss Rs 10,000)
2022-23 Rs 45,000 (excluding Rs 5000 insurance premium)
2023-24 Rs 60,000
2024-25 Rs 80,000(including profit on sale of building Rs 20,000)
You are required to calculate the value of goodwill at 2 years purchase of
average profits.
Weighted Average Method
5) ABC ltd purchased the business of XYZ ltd. calculate goodwill on the basis
of 3 years purchase of weighted average for 4 years. The appropriate weights
are : 2021-22 – 1, 2022-23 -2.5, 2023-24 – 3.8 and 2024-25- 4.2
The profits for these years were Rs 40500, Rs 46500, Rs 60,000 and Rs
75,000 respectively. On scrutiny of accounts, the following aspects were
revealed:
a) The company purchased new furniture on 30th September 2023 which
was entered in purchase day book. The value of furniture was Rs 10,000.
For the purpose of goodwill the error has to be rectified and depreciation
should be provided at 10% under written down value method
b) The opening stock of year 2023-24 was under valued by Rs 2500
c) Anticipated additional expenses in administration is Rs 5000 per annum.
6) Giri ltd proposed to purchase the business carried on by Mr.Srinivas.
goodwill for this purpose is agreed to be valued at 3 years purchase of the
weighted average profits of the past 4 years, the appropriate weights to be
used are:
2021-22 1
2022-23 2
2023-24 3
2024-25 4
The profits for these years are:
2021-22 Rs 1,01,000
2022-23 Rs 1,24,000
2023-24 Rs 1,00,000
2024-25 Rs 1,50,000
On a scrutiny of the accounts the following matters are revealed:
a) On 1-4-2023 a major repair was made in respect of the plant incurring Rs
30,000 which amount was charged to revenue. The said sum is agreed to
be capitalized for goodwill calculation subject to adjustment of
depreciation of 10% p.a on reducing balance method.
b) The closing stock for the year 2022-23 was over valued by Rs 12,000
c) To cover management cost an annual charge of Rs 24,000 should be
made for the purpose of goodwill valuation.
Compute the value of goodwill of the firm
Capitalization method:
The capitalization method can be sub-divided into two types:
a) Capitalization of average profits
b) Capitalization of super profits
Capitalization of average profits:
Stpes :
Step-1: calculation of adjusted average profits:
The adjusted average profits of the business can be found out in the same manner
as in the case of average profits method.
Step-2: calculation of total value of the business:
The total value of the business can be found out with the help of the following
formula:
Total value of business=adjusted average profits / normal rate of return*100
Step-3: calculation of goodwill
The goodwill can be ascertained by deducting the net assets of the business (i.e
assets minus liabilities) or capial employed from total value of the business.
Goodwill =total value of the business - capital employed (i.e assets – liabilities)
Capitalization of super profit:
Under this method the value of goodwill can be ascertained directly by
capitalizing its super profits on the basis of normal rate of return with the help of
the following formula
Goodwill= super profit / normal rate of return * 100
Problems:
7) The net profits of a company for the past 5 years are:
2020-21 Rs 40,000
2021-22 Rs 45,000
2022-23 Rs 47,000
2023-24 Rs 40,000
2024-25 Rs 48,000
The capital employed in the business is Rs 4, 00,000. On which a reasonable
rate of return is expected at 10%. Calculate the goodwill of the company
under capitalization of the average profits method.
8) A company desirous of selling its business to another company has earned
an average past profit of Rs 1,60,000 per annum and the same amount of
profit is likely to be earned in the future also except that:
a) Directors fees Rs 12,000 per annum charged against such profits will not
be payable by the purchasing company whose existing board can manage
the new business also
b) Rent of Rs 28,000 per annum which had been paid by the vendor
company will not be incurred in the future since the purchasing company
owns its own premises and the necessary accommodation can be
provided.
The net assets other than goodwill were Rs 18, 00,000 and it was
considered that a reasonable return on investment in this type of business
would be 10%.
Super profit method:
It is the difference between the average profits earned by the business and the
normal profit based on the normal rate of return.
Normal rate of return:
It refers to the rate of earnings which investor in general expect on their
investments in a particular type of industry. It varies depending upon general
factors like the bank rate, general economic conditions, political stability and
specific factors like period of investment, risk attached to the investment etc
Steps for calculation of goodwill under super profit method:
Step -1: calculation of adjusted average profits
The adjusted average profits of the business can be found out in the same
manner as in the case of average profits method.
Step -2: calculation of average capital employed
It may be ascertained using asset based approach
Particulars Rs
Market value of Assets:(other than non-
trading assets like investments , goodwill
and past deffered expenses and losses like
preliminary expenses, discount on issue of
shares and debentures etc)
At market value on the balance sheet date
Land and buildings
Plant and machinery
Furnitures
Patents and trademarks
Motor vehicles
Cash in hand
Cash at bank
Sundry debtors
Bills receivable
Stock in trade
Prepaid expenses
Less: total liabilities to outsiders at revised
value if any
Debentures
Mortagage loans
Unsecured loans
Fixed deposits from public
Sundry creditors
Bills payable
Bank overdraft
Unclaimed dividend
Provision for taxation
Proposed dividend
Employees provident fund
Workmen’s savings bank a/c
Depreciation fund
Capital employed at the end of the year
Less: half of the profits earned during the
year
Average capital employed for the year
Note:
a) When capital employed is given in the problem, there is no need to calculate
the average capital employed
b) Non-trading assets means assets acquired because of spare funds such as
investment in government securities, preliminary expenses, past losses etc.
Step-3: calculation of normal profits
Normal profit= average capital employed * normal rate of return
Step-4: calculation of super profit
This can be calculated as follows:
Adjusted average profits
Less: normal profits
Super profits
Step -5: calculation of goodwill
The value of goodwill of the concern can be ascertained by multiplying the
super profits of the business by the given no of years purchase of super profits
Goodwill= super profits* no of years of purchase
Problems:
9) From the following particulars relating to the business of Ashwini, compute
the value of goodwill on the basis of 3 years purchase of super profits taking
average of last 4 years
Fixed assets Rs 8, 00,000
Current assets Rs 80,000
Current liabilities Rs 1, 60,000
Normal rate of return 15%
Managerial remuneration if employed elsewhere Rs 10,000 p.a
Profits for the last 4 years were Rs 1, 20,000, Rs 140,000, Rs 1, 30,000 and
Rs 150,000 respectively
10) Following is the Balance Sheet of Sharad Ltd for the year ended 31-3-
2025
Liabilities Rs assets Rs
Share capital : Fixed assets :
10,000 shares of Rs 10 1,00,000 Buildings 1,00,000
each Machinery 50,000
Reserve and surplus:
Profit and loss a/c 10,000 Current assets:
Profit for 2014-15 80,000 90,000 Debtors 50,000
Secured loans: Stock 40,000
7% debentures 70,000 Cash 60,000
Current liabilities:
Creditors 40,000
3,00,000 3,00,000
Normal rate of return on average capital employed is 10%. Find out the
value of goodwill on the basis of 2 years purchase of super profit. Buildings
are revalued at Rs 150,000 and machinery at Rs 40,000. All other assets are
worth their book values.
H.W.
11) Following is the Balance sheet of Chandana ltd as on 31-3-25
Liabilities Rs Assets Rs
Share capital 30,00,000 Fixed assets 20,00,000
Reserves and surplus 7,50,000 Current assets 25,00,000
Creditors 12,50,000 investments 5,00,000
50,00,000 50,00,000
The investments are 8% government bonds. The net profit after taxation for
the past 4 years were Rs 7,85,000, Rs 8,45,000, Rs 850,000 and 8,60,000
respectively. Normal rate of return on average capital employed is 20%.
Calculate the goodwill at 3 years purchase of super profits.
12) Sri Ram has invested a sum of Rs 3, 00,000 in his own business which
is a very profitable one. The annual profit earned from his business Rs
60,000 which included a sum of Rs 10,000 received as compensation for
acquisition of part of his business premises.
The money could have been invested in deposits for a period of 5 years at
10% interest and himself could earn Rs 7200 per annum in alternative
employment.
Considering 2% as fair compensation for the risk involved in the business.
Calculate the value of goodwill of his business on capitalization of super
profits at a normal rate of return of 12%.
13) The net profit of a business after providing for taxation for the past 5
years are: Rs 80,000, Rs 92,000, Rs 85,000, Rs 1,05,000 and Rs 1,18,000.
The capital employed in the business is Rs 8,00,000. The normal rate of
return expected in this type of business is 10%. It is expected that the
company will be able to maintain its super profit for the next 5 years.
Calculate the value of goodwill on the basis of
a) 5 years purchase of super – profit method
b) Capitalization of super profit method.
Annuity method:
Under this method the goodwill of a concern is ascertained by taking into account
the present value of an annuity for a certain number of years at a certain rate of
interest. The super profit of the business is multiplied by the present value of the
rupee ascertained from the annuity tables:
Value of goodwill= super profits* annuity value
14) The net profit of a business for the past 5 years are: Rs 45,000, Rs
42,000, Rs 45,000, Rs 46,000 and Rs 47,000. The capital employed in the
business is Rs 4, 00,000. The normal rate of return expected is 10% of
average capital employed. It is expected that the company will be able to
maintain its super profit for the next 5 years. Calculate the value of goodwill
on the basis of
a) 5 years purchase of the super–profit method
b) Annuity of super profit (p.v of annuity of one rupee for 5 years at 10%
is Rs 3.78).
c) Capitalization of super profit method.
15) The Balance sheet of MSD ltd as on 31-12-24 is as follows:
Liabilities Rs Assets Rs
Equity shares of Rs 10 2,50,000 Fixed assets 2,00,000
each Investments (5% govt 50,000
General reserve 1,00,000 bonds)
Profit and loss account 50,000 Current assets 2,00,000
Current liabilities 50,000
4,50,000 4,50,000
Net profit after taxation:
2022 Rs 65,000
2023 Rs 62,500
2024 Rs 75,000
Normal rate of return is 10%
Current assets are to be taken at Rs 2, 10,000
Ascertain the value of goodwill
a) 4 years purchase of super profits
b) Capitalization of super profits
c) Annuity of super profits taking annuity factor Rs 1 for five years at 10%
as Rs 3.78.
