Explained: Goodwill on the balance sheet of a company

Shreya Chaware
/ Categories: Knowledge, Fundamental
Explained: Goodwill on the balance sheet of a company

Building goodwill builds value!

Introduction to the concept of goodwill  

Goodwill is defined as the value of the reputation of a firm built over time, taking into consideration the expected future profits over and above the normal profits. Goodwill is an intangible real asset, which cannot be seen or touched but has an existence in reality and can also be purchased & sold. Goodwill valuation plays an important role in a partnership.   

Goodwill makes an appearance when a company acquires another company. The amount of goodwill can be calculated as the cost to purchase the business less the fair market value of the tangible assets along with the intangible assets that can be identified and the liabilities obtained in the purchase.   

How to calculate goodwill?  

To calculate goodwill, we should take the purchase price of a company and subtract the fair market value of identifiable assets & liabilities.  

Goodwill = P−(A+L)  

where,  

P = Purchase price of the target company  

A = Fair market value of assets  

L = Fair market value of liabilities  

Types of goodwill  

There are two distinct types of goodwill:  

Purchased: Purchased goodwill can be calculated as the difference between the value paid for an enterprise as a going concern and the total sum of its assets less the sum of its liabilities, each item of which has been separately identified & valued.  

Inherent: It is the value of the business in excess of the fair value of its separable net assets. It is tagged as internally-generated goodwill, which arises over a period of time due to the good reputation of a business. In other terms, it can also be called self-generated or non-purchased goodwill.  

The presence of goodwill shows that the company's value is greater than its combined raw assets. The effect of goodwill on a company's value can be better internalised by learning the factors that create business goodwill. The three factors in the creation of a company's goodwill are going concern value, excess business income, and the expectation of future economic benefits.  

To summarise in a nutshell, goodwill has a major impact on value because it reduces the risk that a business’ profitability will falter after it changes hands. Due to goodwill, a company with a positive reputation grows in value. Customers recognise the value of goodwill of a company, which enables us to attract more investors. In the case of business expansion, it can also help in receiving credit more easily. On the other hand, if you choose to sell your business, it will enable you to make a larger profit. Building goodwill builds value! 

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