Subtracting the fair market value of a small business’s net identifiable assets from the price paid for the acquired business is one of the simplest ways to calculate goodwill.
When one company buys another, the intangible asset known as goodwill is created. A company’s purchase price frequently exceeds its book value. Goodwill is the difference between a company’s purchase price and its book value. It’s critical to account for goodwill in order to keep the parent company’s books in order.
In this article, we will cover the following:
- What Is Goodwill?
- How to Calculate Goodwill for a Small Business?
- Goodwill Calculation Methods
- How to Calculate Goodwill on Acquisition?
What Is Goodwill?
The premium paid during the acquisition of a business is known as goodwill.
When a company is bought for more than its book value, the buyer is paying for intangibles like brand recognition, skilled labour, and customer loyalty.
How to Calculate Goodwill for a Small Business?
The fair value of the acquired business’ assets and liabilities is added to the fair value of the business’ assets and liabilities to calculate goodwill. Goodwill is the difference between the price and the fair value of net identifiable assets.
The formula for goodwill is:
Goodwill = (Consideration paid + Fair value of non-controlling interests + Fair value of equity interests) – Fair value of net identifiable assets
Example of a Goodwill Calculation:
- For $2 million, company X buys company Y.
- Company Y has a total asset value of $1.4 million and a total liability value of $20,000.
- The company’s net identifiable assets are $1.4 million minus $200,000, for a total of $1.2 million.
- $800,000 is the difference between $2 million and $1.2 million in goodwill.
- This means that company X paid a $800,000 premium over its net identifiable assets to obtain its unidentified assets, which increased its earning power.
- A company’s goodwill account is found in the assets section of its balance sheet.
Goodwill Calculation Methods
Average Profits Method
The value of goodwill is calculated using this method as the average profits over a specified time period. It’s calculated by multiplying the average profits by the number of years it takes to buy something.
Goodwill = Future Maintainable Profit After Tax x Number of Years’ Purchase
Super Profit Method
The difference between estimated future profits and average profits is known as super profit. You’ll need to calculate the average profits from previous years to use this method.
Super Profit = Average maintainable profits – Normal Profits
Goodwill = Super Profit x Number of Years’ Purchase
Capitalization of Profits
The capitalization method specifies how much capital is required to generate average or super-profits, assuming the business earns a typical rate of return in the industry.
The capitalized value of profits refers to this amount of capital. Goodwill is defined as the excess of capital over total capital employed by the business.
Capitalized Value of Average/Super Profits = Average/Super Profits X (100 / Normal Rate of Return)
Goodwill = Capitalized Value of Average/Super Profits – Capital Employed
How to Calculate Goodwill on Acquisition?
- Obtain the Assets’ Book Value
Fixed assets, current assets, noncurrent assets, and intangible assets are all included in the book value of all assets.
- Determine the Assets’ Fair Market Value
The next step is to determine the fair value of the assets, which also represents the value of a company’s assets when the financial statements of a subsidiary company are consolidated with those of a parent company.
- Make the necessary changes.
Determine the difference between the fair value and the book value of each asset and adjust the books of accounts accordingly.
- Excess Purchase Price Calculation
The excess purchase price is the difference between the actual purchase price paid to acquire the target company and the net book value of the assets (assets minus liabilities).
- How to Determine Goodwill
To calculate goodwill, subtract the fair value adjustments from the excess purchase price. Following the acquisition, this will be recorded in the acquirer’s balance sheet.
The Generally Accepted Accounting Principles (GAAP) require that goodwill be recorded only when an entire business or business segment is purchased. To record and report it as an intangible asset on the balance sheet, there must be an actual figure or dollar amount.
Despite being an intangible asset, calculating and recording goodwill is an important part of the business valuation.