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Goodwill: Meaning, Factors Affecting Goodwill and Need for Valuation

Last Updated : 06 Apr, 2023
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What is Goodwill?

Goodwill is an intangible asset that represents the market value of a business firm. In simple words, Goodwill is a monetary value of a reputation of a business firm in the market, earned by the owner through his/ her hard work and best quality service. Goodwill of the firm enables the firm to earn supernormal profit in the long run and increases its competitiveness in the market. Goodwill of any business unit is an outcome of the satisfaction of its customers, good employee relationships, a strong consumer base, a big brand name, and so on. Goodwill is an asset that does not depreciate, but its value fluctuates depending on the earnings of the firm, i.e., the value of the goodwill declines with a decline in the earnings. It should, however, be noted that goodwill is an intangible asset and not a fictitious asset as fictitious assets do not have value, but goodwill always has value in relation to profit-making concerns. 

Factors Affecting the Value of Goodwill:

Any factor that affects the profit-making capacity of a firm, affects the goodwill of the business. Some of the factors affecting goodwill have been discussed below:

1. Location of the Firm:

If the business unit is located in the prime market area, then the firm enjoys the attention of more customers, which means more profit. When the profit of the firm is rising, the value of goodwill also rises. Similarly, if the firm is located in a backward area, or is a part of an undeveloped market area, less customers will visit the place due to which the firm’s earnings will be less, thereby decreasing the value of goodwill of the firm.

2. Life Span of the Firm:

 A firm that has been serving society for a number of years has more satisfied customers, a strong brand name, improved customer services, etc. Therefore, an older business unit will have a strong customer base and a high reputation in the market compared to newly established units. So, the older the business, the more is the value of the goodwill.

3. Efficient Management:

The development of any business unit depends upon the efficiency of the management. A business operated under the supervision of efficient managers will earn more profit, and is likely, to enjoy a high value of goodwill in the market. If a manager fails to properly execute the management plans, the financial position of the business is hampered, which ultimately decreases the value of goodwill of the firm.

4. Risk Factor:

A business with a high-risk factor fails to win the trust of the stakeholders, like investors, bankers, lenders, customers, etc. When the risk involved is high, a business firm fails to attain its capital requirements, which in turn hampers the execution of a managerial plan and the profit-making ability of the firm. All this adversely affects the value of goodwill. So, it can be concluded that the higher the risk, the lower the value of goodwill.

5. Nature of the Goods:

If a firm deals in the necessary items or daily use products, it is likely to have a more stable profit and regular customers, which increases the value of the goodwill. Similarly, firms selling trendy goods have unstable sales and profits, as it fails to attract more customers and will have less value of goodwill comparatively. 

6. Nature of the Firm: 

The nature of the business firm highly affects the goodwill of the business unit. If the firm enjoys monopoly rights in a market, there is an assured profit earning, as there is no competition in the market. On the other hand, in a competitive market, every firm has to work harder every day to build a reputation in the market. Hence, a competing firm has a low value of goodwill compared to a monopoly firm.

7. Trend of Profit:

 A profit trend of a firm depends on a number of business factors, like a boom period, efficient management, product trends, service quality, etc. If the profit of a firm is rising continuously, the value of the goodwill will also rise simultaneously, and if the profit of a firm tends to fall, the value of goodwill will also start falling.

8. Capital Requirement:

A business unit with less capital requirement and a high rate of profit-making shall enjoy more goodwill than a firm with more capital requirements and a low rate of profit-making. This is because when a small or medium scale business with less financial investment makes a large profit, it attracts more investors and has a strong financial position, which builds ups a good reputation of the firm in the market, thereby increasing the value of the goodwill.

9. Product Quality:

The market reputation of any firm depends upon its customer base and a satisfied customer base is a result of the quality products.  If the firm offers best quality products and services, then it will rule the major part of the market, thereby earning high profit and a strong reputation in the market. So, the better the quality of the goods, the more is the goodwill.

10. Technological Advancement:

 Technological Advancement requires huge capital investment. Such capital investment by a firm indicates a strong financial position, which builds up the reputation of the firm in the eyes of the stakeholders. Moreover, a business that uses advanced technology for production has a high-profit margin, as the cost of production decreases. Such increased repetition and high profit boost the value and goodwill of the firm.

Need for Valuation of Goodwill:

The valuation of goodwill is done under the following circumstances:

1. A Change in Profit-Sharing Ratio:

Sometimes it becomes necessary to change the existing profit-sharing ratio among the partners because of a change in the capital contribution or change in active participation. As a result of such changes, some partners(sacrificing partners) have to surrender some of their shares in favour of other partners(gaining partners). Therefore, to maintain equity among the partners, goodwill is required to be valued to calculate the amount of compensation, gaining partners shall pay to the sacrificing partners. There are three methods to value Goodwill:

2. Admission of a New Partner:

Admission of a new partner leads to the reconstitution of a partnership firm. This causes a change in the existing profit-sharing ratio among the partners. When a new partner enters the firm, generally the existing partners have to surrender some of their shares in favour of the new partner. Besides this, the new partner also enjoys a ready-made reputation in the market. Under such a case, it becomes necessary to value the goodwill to find the amount that the new partner shall bring as compensation for enjoying the shares of the sacrificing partners, and such compensation is paid based on a proportionate amount of goodwill. 

3. Retirement of an Old Partner:

When a partner retires from a firm, his/her share of the goodwill shall be enjoyed by the continuing partners. Now here, the retiring partner shall be the one sacrificing the shares in favour of the continuing partners, who are also the gaining partners. As a result of this, the continuing partners shall pay the compensation to the retiring partner in the proportion of the value of the goodwill of the firm. Hence, the valuation of goodwill becomes necessary in case of the retirement of an old partner. 

4. Death of a Partner:

The sudden death of the partner causes a reconstitution of the partnership firm as in the case of the retirement of a partner.. The continuing partners( gaining partners) shall take over the shares of the deceased partner( sacrificing partner) and shall pay the compensation for such takeover based on a proportionate amount of goodwill to the nominee of the deceased partner. The valuation of goodwill is needed under such conditions to calculate the amount to be paid to the deceased partner by the continuing partners. 

5. Sale or Amalgamation of the Firm:

The valuation of goodwill is done when a business firm is been sold, to accurately calculate the purchase consideration of the firm, i.e., the actual amount which has to be paid or received while selling the firm.

6. Amalgamation:

Amalgamation is a condition under which two or more firms are combined to form a new entity. Under this, the assets and liabilities of the transferor firm are taken over by the transferee firm, so valuation of goodwill becomes necessary to accurately calculate the amount of consideration to be paid by the transferee company.   

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