What is goodwill? Basically, it is nothing but the excess of payment made for a business in comparison to its fair value in the market. This difference is the value of the goodwill of that business. But, do we calculate goodwill in the case of purchase or sale of a business only? No. There are various circumstances when the need to value goodwill arises. These may include conversion of business from one form to another, entry or exit of partners, change in profit sharing ratio, valuation of shares, business takeover, split of business, etc. Also, goodwill is an intangible asset for the business. There are various methods of calculating goodwill, one of which is the super profit method. Let us discuss here about how to calculate goodwill as per the Super Profit method.
Super Profit Method
Super profit is the excess of profit that a business earns over and above its normal profit. This normal profit is determined on the basis of the normal rate of return prevailing in the industry/ what other businesses in the same industry are earning.
The formula for calculating goodwill using the super profit method is as follows:
Goodwill (using Super Profit Method) = Super Profit * Number of Years’ Purchase
Where Super Profit = Average Future Maintainable Profit – Normal Expected Profit
Hence, the above formula can also be written as follows:
Goodwill (using Super Profit Method) = (Average Future Maintainable Profit – Normal Profit) * Number of Years’ Purchase
How to Calculate using Calculator?
Enter the following figures into the calculator for getting the amount of goodwill as per the super profit method:
Average Future Maintainable Profit
It means the average profit of a business under consideration that it expects to earn in a normal case scenario. Such average profit is adjusted against the abnormal or non-recurring nature of transactions that occurred in the past.
Normal profit refers to the profit that a business earns under normal circumstances. Or, we can say that it is the normal rate of return of the industry. The business houses operating under that industry earn the normal rate of return of that industry on their capital employed.
Also Read: Methods for Valuation of Goodwill
The formula for calculating normal profit is:
Normal Profit = Capital Employed * Normal Rate of Return
You can also use our calculator for calculating capital employed – Capital Employed Calculator.
Number of Years’ Purchase
It is the total number of years for which the business is expected to earn such super-profits.
For more clarity, let us try to solve an example of the super profit method. Consider the following data of Fin Inc.
The profit of the company over the past three years is as follows:
|Years||Year 1||Year 2||Year 3|
And the total assets of the company are $41,000, and the creditors of the company are $6,400. The company earns a normal profit at the rate of 10%. And its number of years purchase is 2.5
Average Future Maintainable Profit = (22,500 + 26,000 + 23,500)/3 = 24,000
Capital Employed = 41,000 – 6,400 = 34,600
Normal Profit = 34,600 * 10% = 3,460
Super Profit = 24,000 – 3,460 = 20,540
Goodwill (under Super Profit Method) = 20,540 * 2.5 years of purchase = 51,350