Meaning of Goodwill
Goodwill is an intangible but not fictitious assets which means it has some realisable value. From the accountants’ point of view goodwill, in the sense of attracting custom, has little significance unless it has a saleable value. To the accountant, therefore, goodwill may be said to be that element arising from the reputation, connection, or other advantages possessed by a business which enables it to earn greater profits than the return normally to be expected on the capital represented by the net tangible assets employed in the business. In considering the return normally to be expected, regard must be had to the nature of the business, the risks involved, fair management remuneration and any other relevant circumstances.
The goodwill possessed by a firm may be due, inter alia, to the following:
1. The location of the business premises, the nature of the firm’s products or the reputation of its service.
2. The possession of favourable contracts, complete or partial monopoly, etc.
3. The personal reputation of the promoters.
4. The possession of efficient and contented employees.
5. The possession of trade marks, patents or a well-known business name.
6. The continuance of advertising campaigns.
7. The maintenance of the quality of the firm’s product and development of the business with changing conditions
The need for evaluating goodwill may arise in the following cases:
1. When the business or when the company is to be sold to another company or when the company is to be amalgamated with another company;
2. When, stock exchange quotations not being available, shares have to be valued for taxation purposes, gift tax, etc.;
3. When a large block of shares, so as to enable the holder to exercise control over the company concerned, has to be bought or sold; and
4. When the company has previously written off goodwill and wants its write back. In valuation of goodwill, consideration of the following factors will have a bearing:
(a) Nature of the industry, its history and the risks to which it is subject to.
(b) Prospects of the industry in the future.
(c) The company’s history — its past performance and its record of past profits and dividends.
(d) The basis of valuation of asset of the company and their value.
(e) The ratio of liabilities to capital.
(f) The nature of management and the chance for its continuation.
(g) Capital structure or gearing.
(h) Size, location and reputation of the company’s products.
(i) The incidence of taxation.
(j) The number of shareholders.
(k) Yield on shares of companies engaged in the same industry, which are listed in the Stock Exchanges.
(l) Composition of purchasers of the products of the company.
(m) Size of block of shares offered for sale since large blocks very few buyers would be available and that has a depressing effect on the valuation. Question of control, however, may become important, when large blocks of shares are involved.
(n) The major factor of valuation of goodwill is the profits of the company. One who pays for goodwill looks to the future profit. The profits that are expected to be earned in future are extremely important for valuation of goodwill. The following are the important factors that have a bearing on future profits:
(i) Personal skill in management
(ii) Nature of business
(iii) Favourable location
(iv) Access to supplies
(v) Patents and trade marks protection
(vi) Exceptionally favourable contracts.
(vii) Capital requirements and arrangement of capital.
(o) Estimation of the profits expected to be earned by the firm and the amount of capital employed to earn such profits, are to be computed carefully.
(p) Market reputation which the company and its management enjoys.
(q) Returns expected by investors in the industry to which the firm or company belongs.