If a company is acquired against payment, the goodwill of the purchased company must be shown in the balance sheet of the purchaser. The goodwill, also known as goodwill or enterprise value, is not a physical object. The balance sheet item is one of the intangible assets of a company. It is reported on the assets side of the balance sheet under fixed assets. For this reason, forecasts are also largely used, which ultimately represent goodwill. Why it is important to know your own goodwill is explained in this article.
How is goodwill defined?
The definition of goodwill (DoG) is derived from the provision of § 246 paragraph 1 sentence 4 of the UK Commercial Code. According to this provision, the GoF represents the difference between the total value of the company and the sum of the individual assets minus the debts at the time of the takeover. If there is original goodwill, the own company has created it itself. In this case, the goodwill is represented by the customer base and the brand of the company. Derivative goodwill was acquired for a consideration.
The relevant factors for determining goodwill are the value of the entire company and all assets and liabilities. If the calculation results in a positive value, this is called goodwill. If the enterprise value is negative, it is badwill.
Goodwill plays an important role when selling the company
Goodwill is only determined if a company is sold in its entirety. When parts of the company are sold, goodwill is often used to determine a purchase price. In addition to the value of the company and all assets and liabilities, a company value is influenced by the following factors:
- What are the future prospects for the company?
- Which competitors must be kept in mind?
- Which technological changes must be reacted to?
- What does the company’s product range look like?
- Can the company stand out from the competition? If these questions are answered in the negative, the company’s valuation is worse.
- What does the company’s customer structure look like? Is there a broad customer base with which the company is well positioned?
Answering these questions can be decisive for the sale and can play an important role in determining the company’s value.
The determination of goodwill
Goodwill can be determined in various ways. The capitalized earnings value method and the Ebit method are presented.
The capitalized earnings value method
If the capitalised earnings value method is applied, goodwill is measured according to what an investor can earn from the purchase of the company. The average of the earnings from the last three years and the forecast earnings for the next three years form the basis of the calculation. The total income is divided by the capitalization interest rate. The capitalization interest rate is made up of the base interest rate and a premium for the entrepreneurial risk. If a small business is to be sold, the interest rate is between ten and fifteen percent. If the average proceeds amount to 1 million GBP and the entrepreneurial risk is ten percent, the enterprise value is 1.1 million GBP.
If the business value is determined in this way, there are two disadvantages. Future earnings are difficult to predict. The interest rate cannot be determined objectively.
The Ebit method
In the Ebit procedure, the profit of the company to be sold plays a decisive role. To determine the goodwill, the profit is multiplied by a factor. A profit of 200,000 GBP and a factor of 4 results in a goodwill (Ebit) of 800,000 GBP.
The applied factor depends on the industry. It is recalculated at regular intervals.
The amortization of goodwill
Positive goodwill can be amortized between five and ten years in accordance with the provisions of commercial law. How long the actual amortization period runs is at the discretion of the company. If there is a permanent reduction in value – the purchased company proves to be unprofitable – the strict lower of cost or market principle must be observed. This means that the DoG is to be written off unscheduled.
What is the relevance of goodwill for entrepreneurs and investors?
Every entrepreneur wants to know what his company is worth. Especially if you as a self-employed person want to sell your company, what you get for your company. There are different ways to look for a buyer.
Databases and networks provide information about solvent managers who are looking to run their own business. The entrepreneur can also look around at his competitors. For the acquirer, the offer is worthwhile from two perspectives. He owns a company that suits his industry and has one less competitor. To be in a better negotiating position, the seller should make more than one offer. If his company has a good business value, this strengthens his position.
Important facts about goodwill
If a company or shares in a company are sold, the goodwill must be determined. The GoF can be determined using the capitalized earnings value method or the EBIT method.
Goodwill is determined by comparing the value for the entire company and all assets less liabilities. In addition, the factors future prospects, product range, customer structure and personnel are important parameters.
Goodwill plays a decisive role for entrepreneurs and investors. The higher it is, the better the company is positioned. This is a benefit for both sides.