Overview
Goodwill is the super-normal earning capacity of a business entity, vis-à-vis other similar firms in the industry or market.
If a firm provides its customers with an extra value in terms of better goods or services vis-à-vis the price it charges, the customers return it with their sustainable patronage, loyalty, good word-of-mouth, etc. It increases the brand image and brand value of the firm. It translates into super-normal earning capacity of the firm, i. e. goodwill.
It is an intangible asset, and therefore, some firms show it in their balance sheet.
Per my understanding following are the 2 estimates of the value of goodwill...
(1)
Market value of the firm - (Replacement value of fixed assets + Net realizable value of current assets - External liabilities)
Note: Market value and market capitalization are identical.
(2)
Average annual profit of the firm ÷ Average annual return on risk-free securities - Net capital employed
Notes:
Both the averages need be calculated for the entire period of firm's operations.
Net capital employed need be calculated after the revaluation of all the assets and liabilities.
Definitions
Business: A business firm is an entity which uses land, labor, capital, and organization to produce useful goods or service; or trade(buy and sell) them; or render non-trading commercial services, e.g. transport, insurance, banking/finance, advertising, communication, warehouse, etc. through recurring exchange for earning profit. It involves risk and uncertainties.
Supernormal profit: If a firm earns a return on investment/capital employed at a rate much higher than the median or modal rate of return of industry/market/line, it is said to be earning supernormal profit.
Risk-free securities: These are securities,e.g. bonds etc. issued by government or statutory bodies/agencies.
Market value of the firm: It the price that one needs to buy that firm in an arm's length transaction.
Market capitalisation: If the firm is listed on a share market,i.e. stock exchange, its market capitalization is equal to the unit share price multipled by the number of shares issued.
Capital employed: It is the actual amount of money invested in the business in the form of various fixed and current assets.
Intangible assets: These assets are those assets which do not have any material existence. It means they cannot be touched or seen; nor do they have weight or volume or mass. However, their existence may be felt by a firm in terms of super-narmal or windfall profit.
It is considered to be the most rigid (least liquid) asset; and therefore shown before any other assets in the balance sheet of the firm. As it is an intangible asset, it cannot be sold or mortgaged easily and much later than sooner.
A firm may quantify and record the value of goodwill on the their books of accounts; if it is self generated as explained in the prologue.
However, if it has been bought in an arm's lenght transaction; its historical cost price should be recorded in the books of accounts.
It is prudent not to show self generated goodwill; and acquired goodwill should be written off with the super-normal profit, if any, owing to this acquired goodwill and its effect on the firm's turnover and profitability.
Illustration:
I. Let's assume the following... regarding a firm.
Market value/Market capitalisation = Rs.100
Replacement value of fixed assets = Rs. 50
Net realisable value of current assets = Rs. 30
External liabilities = Rs. 20
Ergo, goodwill = Rs.100- (50+30-20) = Rs.40.
II. Let us assume the following... regarding a firm.
Average annual profit = Rs. 10
Average annual yield on risk-free securities = 10% = 0.10
Net capital employed = Rs.60.
Ergo, goodwill = Rs.10 ÷ 0.10 - Rs.60 = Rs.100 - Rs.60 = Rs.40.
Note: This blog may be read in Hindi at sunamcj.blogspot.com
Goodwill is the super-normal earning capacity of a business entity, vis-à-vis other similar firms in the industry or market.
If a firm provides its customers with an extra value in terms of better goods or services vis-à-vis the price it charges, the customers return it with their sustainable patronage, loyalty, good word-of-mouth, etc. It increases the brand image and brand value of the firm. It translates into super-normal earning capacity of the firm, i. e. goodwill.
It is an intangible asset, and therefore, some firms show it in their balance sheet.
Per my understanding following are the 2 estimates of the value of goodwill...
(1)
Market value of the firm - (Replacement value of fixed assets + Net realizable value of current assets - External liabilities)
Note: Market value and market capitalization are identical.
(2)
Average annual profit of the firm ÷ Average annual return on risk-free securities - Net capital employed
Notes:
Both the averages need be calculated for the entire period of firm's operations.
Net capital employed need be calculated after the revaluation of all the assets and liabilities.
Definitions
Business: A business firm is an entity which uses land, labor, capital, and organization to produce useful goods or service; or trade(buy and sell) them; or render non-trading commercial services, e.g. transport, insurance, banking/finance, advertising, communication, warehouse, etc. through recurring exchange for earning profit. It involves risk and uncertainties.
Supernormal profit: If a firm earns a return on investment/capital employed at a rate much higher than the median or modal rate of return of industry/market/line, it is said to be earning supernormal profit.
Risk-free securities: These are securities,e.g. bonds etc. issued by government or statutory bodies/agencies.
Market value of the firm: It the price that one needs to buy that firm in an arm's length transaction.
Market capitalisation: If the firm is listed on a share market,i.e. stock exchange, its market capitalization is equal to the unit share price multipled by the number of shares issued.
Capital employed: It is the actual amount of money invested in the business in the form of various fixed and current assets.
Intangible assets: These assets are those assets which do not have any material existence. It means they cannot be touched or seen; nor do they have weight or volume or mass. However, their existence may be felt by a firm in terms of super-narmal or windfall profit.
It is considered to be the most rigid (least liquid) asset; and therefore shown before any other assets in the balance sheet of the firm. As it is an intangible asset, it cannot be sold or mortgaged easily and much later than sooner.
A firm may quantify and record the value of goodwill on the their books of accounts; if it is self generated as explained in the prologue.
However, if it has been bought in an arm's lenght transaction; its historical cost price should be recorded in the books of accounts.
It is prudent not to show self generated goodwill; and acquired goodwill should be written off with the super-normal profit, if any, owing to this acquired goodwill and its effect on the firm's turnover and profitability.
Illustration:
I. Let's assume the following... regarding a firm.
Market value/Market capitalisation = Rs.100
Replacement value of fixed assets = Rs. 50
Net realisable value of current assets = Rs. 30
External liabilities = Rs. 20
Ergo, goodwill = Rs.100- (50+30-20) = Rs.40.
II. Let us assume the following... regarding a firm.
Average annual profit = Rs. 10
Average annual yield on risk-free securities = 10% = 0.10
Net capital employed = Rs.60.
Ergo, goodwill = Rs.10 ÷ 0.10 - Rs.60 = Rs.100 - Rs.60 = Rs.40.
Note: This blog may be read in Hindi at sunamcj.blogspot.com
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