When you sell your business, you’re not just selling contracts, equipment, real estate, and inventory. You’re usually selling a going concern which represents the ongoing ability to generate future cash profits. The value of which is also impacted by things like the brand name, location, and customer base, which can be hard to place a specific value on. This is why understanding Goodwill in business is crucial, especially for acquisitions.
What Is Goodwill?
Fundamentally, goodwill is the difference between enterprise value and identifiable asset value. Whilst asset value is typically visible on the balance sheet in the form of current and non-current assets, in most instances goodwill is not. A company is not allowed to recognise internally generated goodwill. If they could, balance sheets would be filled with volatile goodwill balances based on how the directors feel each year about the value of the business!
When a purchaser pays a premium for a business over the value of its assets (Less liabilities), this differential will be the goodwill value. This is no longer an internal number in this scenario, but rather a number achieved through a transaction between parties. Not only does that make it more objective, but we also need a way to make the books of the consolidated group balance.
The accounting rules for goodwill are much less important than the concept itself. The rationale behind the premium paid for goodwill could be the brand, client base, intellectual property, or any number of other reasons. Practically, these elements serve to generate the cash flow that underpins the valuation of the business, hence they are included in the business valuation but not necessarily any of the identifiable assets on the balance sheet.
After all, you recognise the accounts receivable from your debtors, not the value of all sales to them in the future. Accounting is a historical concept, whereas valuations look into the future. This is exactly why the net asset value or book value approach to a valuation is dangerous, as it ignores the drivers of goodwill.
Key Takeaways
- Goodwill is an intangible asset representing the extra amount paid over and above the value of assets and liabilities when purchasing a company.
- It is influenced by elements like intellectual property and brand recognition that are hard to measure in isolation.
- Calculate Goodwill by subtracting the fair market value of assets and liabilities from the purchase price.
- Companies must check and record any changes in Goodwill on their financial statements annually.
- Goodwill has an indefinite lifespan, unlike most other intangible assets, which have a limited useful life.
Goodwill Impairments
Accounting Goodwill relates to asset impairment when an asset’s market value falls below its historical cost. This can happen due to events like declining cash flows, increased competition, or economic depression. A company must adjust the asset’s value on the balance sheet if the acquired net assets are worth less than the book value or if Goodwill is overstated.
Impairment expense or impairment loss is the difference between the current market value and the purchase price of the intangible asset. This reduces the Goodwill account on the balance sheet and appears as a loss on the income statement, lowering net income for the year.
Impairment Tests
Companies determine impairments through tests on intangible assets. Two main methods are used: the income approach and the market approach. The income approach involves discounting estimated future cash flows to their present value. The market approach analyzes the assets and liabilities of similar companies in the same industry.
Impairment tests must adhere to guidelines stipulated by the relevant accounting bodyto evaluate accurately any potential decline in Goodwill’s value. For global businesses, IFRS standards require consistent impairment testing of Goodwill to align with international accounting practices. While public entities must adhere strictly to these standards, private companies might have more flexibility in how they report and assess Goodwill.
Negative and Positive Goodwill
Negative Goodwill
If the value of the business is less than the identifiable asset value, which is possible when a company is severely underperforming and not generating an appropriate return on capital, then goodwill is negative and is called a bargain purchase gain.
For accountants, this is recognised as income rather than an asset. From an economic perspective, this would be a classic case of a company being sold at less than its book value. This isn’t always a desperate situation. Sometimes, an industry changes such that the business cannot generate a sufficient return on capital. To create an outcome where the return becomes high enough, a buyer would only pay a discounted amount for the capital in the business, so the buyer’s effective return on capital is then sufficient.
Positive Goodwill
Negative Goodwill indicates unfavorable circumstances. Positive Goodwill shows high intangible asset value and suggests the company isn’t under pressure to sell, benefiting the seller.
Calculating Goodwill in a Business
Simplistically, Goodwill is calculated by adding the value elements that aren’t identifiable as specific assets. Since this is impossible directly, we must follow a few steps to work backward.
Value the cash flow
There are various approaches that we have covered in other articles and won’t delve into in detail now, but a discounted cash flow or multiples based approach could be used. For the sake of this example, we will assume that a current annual cash flow of $1m from the business is valued at $4m.
Calculate the identifiable net asset value
Next, we determine the current value of the assets and liabilities utilised to generate the cash flow. With a strictly accounting-based lens, this would use the values on the balance sheet as goodwill is the balancing number. For a better economic understanding, goodwill is actually the difference vs. what the assets are worth individually in the open market. This can significantly change the answer where there are assets like properties and depreciated equipment. For simplicity, we’ll assume that the assets are held at market value on the balance sheet and could be sold for $1m. The liabilities are worth $500k. The net identifiable assets are thus worth $500k.
Calculate the Goodwill value
The difference between the value of the cash flow and the identifiable net assets will be the goodwill value. In our example, the net assets worth $500k generate cash flows that suggest a valuation of $4m. In essence, the goodwill value is thus $3.5m as that is the premium being paid for the assets that cannot be specifically identified, like client relationships and the strength of the brand.
5 Steps for Calculating Goodwill in an M&A Model
To summarize the approach and example described above, follow these 5 steps to calculate Goodwill:
1. Book Value of Assets
Get the book value of the assets. Include fixed, intangible, current, and non-current assets.
2. Fair Value of Assets
Next, find the fair value of these assets. Fair value is often set by the market, but there are methods to calculate it. One method is to assess the asset’s discounted cash flows.
3. Adjustments
After finding the book value and fair value of the assets, calculate the difference between the two amounts and record it in the accounts.
4. Excess Purchase Price
Calculate the difference between the actual purchase price and the net book value of the assets (assets minus liabilities). This will give you the excess purchase price.
5. Calculate
First, subtract the fair value adjustments from the excess purchase price. This gives you the Goodwill amount.
How Is Goodwill Different From Other Assets?
Goodwill is an intangible asset created when a company buys another for more than its net asset value. It appears on the balance sheet like other assets. Unlike assets with a clear, useful life, Goodwill isn’t amortized or depreciated. Instead, it undergoes regular tests for impairment. If Goodwill is impaired, its value must be reduced, which decreases the company’s earnings.
Using Goodwill in Investing
If the company being valued already has goodwill on the balance sheet, this is because a prior transaction already took place in which that company bought another company or business. This creates layers of goodwill, which must be treated carefully in a valuation.
The best approach is to ignore that goodwill completely and rather value everything in that group i.e. not just the target company, but also its underlying investments. This would be necessary anyway to achieve a proper valuation. The eventual goodwill will be calculated by considering all the underlying assets controlled by the company (including in subsidiaries), with a few technical adjustments along the way.
In other words, don’t be thrown off by seeing goodwill on a balance sheet. It doesn’t tell you much (or anything, really) about what the company is actually worth today.
Several Factors can Lead to the Creation of Goodwill
In a technical accounting process, there’s an effort made to identify the sources of goodwill and what the underlying intangible assets might be, like the brand. But in all but the most technical applications, there really isn’t much point is trying to determine the contribution made by each of these underlying components. It’s very difficult to do accurately and serves little economic value, which is exactly why the company couldn’t recognise the goodwill in the first place.
In a restaurant, the goodwill will be driven by elements like the location, Google reviews, quality of the menu and lifespan of the brand. These things work together rather than apart, with each part of the chain adding to the overall value. If you’re buying the restaurant, does it really make any difference to try and ascribe an esoteric value to the menu itself, or the location? What you actually care about is the cash profits being generated.
For clarity sake we can explore a few things that influence goodwill.
Existing Brand and Reputation
Goodwill encompasses intangible elements like strong trademarks and patents, business operations, product or service quality, and operational efficiency. Trademarks and patents add to Goodwill by granting exclusive rights, creating barriers for competitors, and potentially increasing profits. A company’s dominant market position, unique business model, or presence in a high-growth industry can also generate Goodwill. These factors may not appear in financial documents but can offer future economic benefits, making it crucial to recognize Goodwill accurately on the acquirer’s balance sheet.
Exceptional Management
A company with a skilled and experienced management team can outperform competitors, draw more customers, and earn higher profits. This management efficiency is intangible and not shown in the company’s physical assets. Therefore, when such a company is bought, the buyer often pays more than the net asset value, leading to Goodwill.
Strong Customer Relationships
A company with loyal customers who frequently buy its products or services enjoys a high customer retention rate. This results in stable and predictable revenue streams. These strong relationships are valuable assets during an acquisition. An acquirer might pay extra for them, creating Goodwill.
Calculating Goodwill in a Business Sale
These are the key methods for valuing a business to determine Goodwill in a business sale:
Simple Multiple Approach
The simple multiple approach is ideal for valuing Goodwill in smaller, straightforward businesses like owner-managed companies. A multiplier, usually between one and five, is applied to maintainable profits before deducting owners’ salaries. The choice of multiplier is subjective and depends on factors like recent business growth and profitability. At bizval we caution against just relying on this simplistic method as it can be misleading without the proper context.
Discounted Cashflow Approach
This method values a business by assessing the present value of future cashflows. If the valuation exceeds the adjusted net asset value, the difference is Goodwill. If it’s less, there’s likely little or no Goodwill in the business.
Turnover Approach
The turnover approach is often used to value professional practices like accountants, solicitors, and architects who charge fees.. A multiplier is applied to the professional fees (which acts as a proxy for profit and cashflow), ranging from 0.5 to 2.5. This range depends on the type of clients and levels of business growth in each practice.
Example of Goodwill
A good example of Goodwill is Disney’s purchase of Pixar. In 2006, Disney acquired Pixar for about $7.4 billion. Pixar had valuable physical assets and intellectual property, such as its animation technology. However, much of the purchase price was for Goodwill. This Goodwill represented the value of the Pixar brand, its creative team, and the benefits expected from combining Pixar’s operations with Disney’s.
How bizval can Empower Your Business?
Goodwill value is often misunderstood, especially by business owners who believe that it is an additional source of value once a valuation has been done, rather than a component of that valuation.
In reality, the cash flow generated by a business already takes into account all the typical elements of goodwill, as that cash flow wouldn’t exist with the customers, brand, product range and IP. But because of accounting rules, the concept of goodwill allows that value to be ascribed to a single line item that represents all the assets that cannot be specifically and separately identified.
Any valuation that tries to show goodwill as an additional source of value is at serious risk of double-counting this concept, unless the goodwill is being shown purely as the difference between the value put forward by the valuation and the value of underlying net assets.
Valuing Goodwill is complex. Simplified methods can become complicated due to specific business factors and subjectivity, leading to disputes. If you’re considering selling your business and need more information on valuing Goodwill, our experts at bizval can guide you. Contact our team for assistance.
FAQs
How to audit Goodwill?
When auditing Goodwill, several key aspects need attention, especially regarding financial reporting standards, to ensure proper compliance and accuracy:
- Review the Acquisitions: Assess past acquisitions for their strategic purpose and rationale.
- Check Impairment Tests: Ensure impairment tests are conducted regularly as per standards.
- Evaluate Financial Statements: Scrutinize financial statements where Goodwill appeared.
- Determine Recoverable Amounts: Verify that recoverable amounts align with economic realities.
- Understand Management Assumptions: Analyze the assumptions used in Goodwill valuation models.
- Identify Potential Red Flags: Look for unusual trends or inconsistencies in Goodwill reporting.
Is Goodwill an asset or an expense?
Goodwill is an intangible asset representing the excess amount paid when buying a company. It includes valuable elements like intellectual property and brand recognition that are hard to quantify.
How does accounting for Goodwill differ from economic Goodwill?
Financial accounting standards permit only accounting Goodwill on a company’s Balance Sheet after an acquisition of a target company. This is because accounting Goodwill reflects a real cost or financial outlay arising from a business combination, such as in a corporate merger or acquisition. Economic Goodwill, on the other hand, is just an estimated financial value not yet realized. (Whether or not it is reflected on the balance sheet)
How do you attribute the value of Goodwill to the brand, customers, market sentiment, etc.?
In a technical accounting process, there’s an effort made to identify the sources of goodwill and what the underlying intangible assets might be, like the brand. But in all but the most technical applications, there really isn’t much point is trying to determine the contribution made by each of these underlying components. It’s very difficult to do accurately and serves little economic value, which is exactly why the company couldn’t recognise the goodwill in the first place.
In a restaurant, the goodwill will be driven by elements like the location, Google reviews, quality of the menu and lifespan of the brand. These things work together rather than apart, with each part of the chain adding to the overall value. If you’re buying the restaurant, does it really make any difference to try and ascribe an esoteric value to the menu itself, or the location? What you actually care about is the cash profits being generated.