Goodwill can be defined as the value of a firm’s reputation, developed over time, with respect to anticipated future profits over and above regular profits. Compared to a new firm, a well-established firm would have earned a good name, built trust with customers, and formed more business connections. Goodwill is an asset that creates value for the firm in the long run. While it has no physical form, it can be bought or sold.

Factors affecting the Value of Goodwill

A firm that manufactures good-quality products can earn more profits than a firm that has low demand because of poor-quality products. The major factors affecting the value of goodwill are:

  1. Location: The firm’s location is important in determining the value of goodwill. A firm located in the main market or at a place that has more customer traffic would earn more profits, leading to more goodwill.
  2. Time: As goodwill is a long-term asset, time influences its value. A well-established firm surely has a better reputation than a newly set up firm, even if they are in the same locality.
  3. Nature of business: Nature of business refers to the type of products manufactured by the firm, the demand for those products, accessibility of raw materials, the competition faced by the firm, and government regulations that affect firm activities; all these factors are considered to determine the value of goodwill. If these conditions work in favour of the firm and it has some kind of monopoly in the market, it would earn more and have more goodwill.
  4. Owner’s reputation: A firm’s goodwill is influenced by the goodwill of its owner. If the owner is truthful and trustworthy, they would have a good reputation in the market; this, in turn, would attract more customers to the business.
  5. Management: When an organisation is efficiently managed, it will have high productivity and increased profits, which help create goodwill.
  6. Capital required: A firm that earns a high profit despite a small amount of capital will attract more buyers than a firm that requires more capital but has a lower profit-earning rate.
  7. Trend in profits: A firm’s goodwill is determined by its earning capacity. If the trend in profit is constantly rising, the firm will have goodwill. However, instability in profits will affect the value of goodwill adversely.

Methods of Valuation of Goodwill

  1. Average profits method: This is of two types:
  • Simple average: Goodwill is evaluated by multiplying the average profit by the number of years since purchase.
  • Weighted average: This method is used when there is a fluctuation in profits.                                                                     
  • Goodwill = weighted average profit * number of years since purchase.
  1. Super profits method: This is used when a firm earns greater profits than estimated. Super profit is calculated by subtracting normal profit from actual profit. Then, this super profit is multiplied by the number of years of purchase, which gives the value of goodwill.
  2. Capitalisation method: This is used to determine the amount of capital to be invested to earn a specific amount of returns. Goodwill is calculated by the formula given below:

  Capitalised average profits = average profits * 100/normal rate of return

  Actual capital employed = total assets – outside liabilities

  Goodwill = capitalised actual profits – actual capital employed

Conclusion

Goodwill is an intangible asset that has no physical form but provides value to the firm. There are several factors affecting the value of goodwill of a firm. These may include profit trends, firm location, nature of business, required capital, and owner’s reputation. Goodwill enhances the value of the business in the long run. Goodwill could be paid for or inherited. Regardless of how it is generated, it helps a firm increase its net value. There are multiple methods of valuation of goodwill that a firm may use according to its needs.