Goodwill, and here we are talking business goodwill, is a long-term (or noncurrent) asset categorized as an intangible asset. My personal choice for a definition is from the Australian Accounting standards and is:
The future benefits from an unidentifiable intangible
There are many factors that lead to goodwill, including but not limited to:
- Superior Management
- Customer confidence
- Market penetration
- Manufacturing efficiency
However, not every business will attract goodwill. Even though the factors above may benefit the business, and lead to a well run profitable enterprise, in the majority of cases, unless the business in question can demonstrate healthy profits, it is doubtful any goodwill will be attributed to the business.
When we talk about business goodwill in this blog, we are looking at SME's. The differing factors involved when valuing public vs. privately valued companies, is like comparing apples to oranges. So with small to medium enterprises, the majority of times a business is sold, what the buyer is getting is the goodwill of the business, the business name, plant and equipment, inventory and other assets. They are not buying the actual company. Invariably, the seller keeps the cash at bank, debtors and creditors and the business is sold unencumbered. So goodwill is the balance of a business sale price, less the tangible assets. Therefore if a business sold for $500,000 the following may apply:
Plant and equipment $ 180,000
Inventory $ 80,000
Goodwill $ 240,000
Total $ 500,000
In the above example the valuation for this business may have been derived using the ratio of a 40% return on a business making a net profit of $200,000.
$200,000 /.4 = $500,000
If the business made a net profit $100,000, then the valuation of the business using the same principles is:
$100,000 /.4 = $250,000
In this instance, there would be no goodwill as the plant and equipment and inventory total more than the valuation price.