Goodwill is the term used to describe the ‘good name’ or ‘reputation’ earned by a firm as it trades. If a business provides a good service to its customers, it is hoped that they will come back again and again to you the services of that firm. This in turn will hopefully have a positive impact on the future turnover and profits of the business. In accounting terms goodwill represents an asset to the business and has a real monetary value.
The main characteristics of goodwill are:
- It belongs to the category of intangible assets which includes other items such as patents, trademarks and copyrights. Goodwill along with these other intangibles are non-physical, fixed assets and are included on the balance sheet.
- It is a valuable asset.
- It contributes to the earning of excess profits. The existence of goodwill is often key to a business earning profits over and above the levels for similar businesses in the same industry.
- Its value is liable to constant fluctuations.
- Its value is only realised when a business is sold or transferred.
- It is difficult to place an exact value on goodwill and it will always involve expert judgement.
The key factors affecting goodwill are:
- The nature of the business. The goodwill relating to a service based business is likely to be different than that of a manufacturing business.
- Favourable location. If a business is situated in a good location it will generally have a positive affect on the value of goodwill.
- Longevity of the business. If a business has been trading for a long period it may have had more time to develop a good solid reputation, and more goodwill.
- Possession of licenses or technical know- how.
- After sales services and general customer care.
- Business risk involved.
- Future competition and new entrants into a specific business marketplace.
- Management’s attitude towards the fulfilment of commitments
Specific circumstances when there is a need for the valuation of goodwill:
- When there is a change in the profit-sharing ratio amongst the existing partners.
- When a new partner is admitted.
- When a partner retires.
- When a partner dies.
- When the business is sold as a going concern.
- When the business is amalgamated with another firm.
Goodwill, although not something that can necessarily be shown in black and white, is a vital component of a business’ worth and whether looking to acquire or sell an established firm it is important not to underrate its value.
