It’s no secret that a business’ perception and standing in the marketplace have a profound effect on its overall financial success. Just look at the positive reputation enjoyed by companies like Apple and Starbucks and how it affects the prices of goods sold! Wouldn’t it be great to assign a dollar value to that positive reputation? One that you could use as part of your business’ valuation?
You can, and it’s called “business goodwill” or just “goodwill.” A crucial asset when determining a company’s overall valuation, goodwill reflects the portion of a company’s value that can’t be ascribed to cash or physical goods. In this sense, a business’ true worth is often far more than the value of its individual—tangible—parts.
Although goodwill is generally regarded as an intangible asset, businesses are required to value it annually and record any impairments, or instances in which market value drops below historical cost. Additionally, individuals looking to acquire existing companies should evaluate the business’ goodwill carefully. Doing this helps ensure a fair price for both parties.
Business goodwill is distinct from “going concern value,” which refers to those assets that contribute to the production of income and may include equipment, facilities and other tangible assets owned by the company. When business goodwill value and going concern value are combined, you have a rough estimate of the business’ overall valuation.
What Affects Business Goodwill?
Various factors affect a company’s business goodwill. When calculating goodwill for your company, it’s important to take all the applicable assets into account. Some of the assets that can be categorized as goodwill include:
- Reputation among customers and professional groups
- Brand-name recognition
- Company website and domain name
- Managerial and executive talent and innovation
- Trade secrets
- Client and supplier lists
- Licenses and permits
- Copyrights, trademarks and patents
- Processes and training systems
The above is only a partial list of the factors that affect a business’ goodwill value. Combined with going concern value, companies should be sure to include all possible value propositions to arrive at the most fair and accurate number.
Accounting for Business Goodwill
Accounting for business goodwill in your books requires that you subtract the fair market value of tangible assets from the total worth of the business. Goodwill is therefore equal to the cost of acquisition minus the value of net assets.
To start, determine the value of net identifiable assets by subtracting liabilities from identifiable assets like inventory and real estate. When valuing assets without clear market rates, such as patents or client lists, you may need to base data on estimates of future cash flow generated from the items in question. Additionally, professional companies like doctors’ offices and law firms will need to account for both practitioner goodwill (i.e. the value of the practitioner’s talents and abilities) and practice goodwill (i.e. the value of the business as a whole).
Some businesses use a cost approach to valuing business goodwill. Under this system, companies estimate the financial cost of recreating the current level of goodwill from scratch. Additionally, companies can utilize comparative data from sales of similar businesses in the industry. Doing this allows businesses to calculate goodwill as a percentage of the sale price.
Recording Goodwill in the Books
While U.S. law does not require businesses to amortize the value of goodwill anymore, they do have a responsibility to subject their goodwill to yearly impairment tests. In the event that future cash flow resulting from the sale of an asset falls below its book value, the business must report the impairment loss in its financial documents.
Companies must compare their goodwill balances to their estimated market values on a yearly basis, and adjust their books to reflect instances in which the carrying values are too high. Additionally, a company should list the value of goodwill on a balance sheet in cases when it purchases another business for a price higher than the recorded value of assets. It’s important to note that businesses cannot have negative goodwill, though this value can be equal to zero.
Business goodwill may be intangible, but that doesn’t mean its calculation is unimportant. By assessing goodwill accurately, you can ensure you don’t overpay on a business purchase or sell your meticulously built company for less than it’s really worth.
If you’re interested in increasing the value of your small business, read four ways to do so here.