Super Profits Method for Evaluation of Goodwill

In this article we will discuss about the Super Profits Method for Evaluation of  Goodwill along with Solved Illustrations.

In this case, the maintainable profits of the firm whose goodwill is for sale are compared with the “normal” profits for the firm, i.e., profits, which would have been earned with the same capital by an average firm.

If the estimated future profits are more than the normal profits, the difference is known as “Super Profits”. This is the measure of the extra profits obtained by the firm. Goodwill is found by multiplying the super profits by a certain number, representing the number of years’ purchase.

Normal profits are ascertained by multiplying the average capital employed by the rate of general expectation (i.e., the rate of yield expected by investors in the industry concerned) and dividing by 100.

To take a simplified example, suppose:

(1) A firm employs Rs 6,00,000 as capital

(2) Investors are not satisfied with an income of less than 20% and

(3) The profits likely to be continued are Rs 2,00,000.

The super profits of the firm are as follows:

Suppose, in the same firm, the profit actually is only Rs 1,10,000. There is no super profit (because the actual profit is less than the normal profits) and hence no goodwill. It is only when actual profits exceed normal profits that goodwill arises.

In case of the super profits method, an important point to note is that the number of years of purchase of goodwill will also differ from industry to industry and from firm to firm. A business where the retiring proprietor was the main reason for success will have goodwill based on one or two years’ purchase of goodwill.

Three to five years’ purchase is common. If the super profits are large, a large number of years’ purchase is allowed. If the profits are declining, the number of years for purchase of goodwill will probably be only one or two.

Theoretically, the number of years is to be determined with reference to the probability of a new business catching up with the old established business. Suppose, it is estimated that in four years’ time a business, if started de novo, will be earning about the same profits as an old business is earning now, the purchaser of the business (old) will not pay for goodwill more than four or five times the super profits.

Illustration 1:

The following is the Balance Sheet of Jute Ltd. as at 31st March, 2012:—

Illustration 2:

On 31st March, 2012 A Ltd. proposes to purchase the business carried on by M/s X Ltd. Goodwill for this purpose is agreed to be valued at three years’ purchased of the weighted average profits for the last four years.

The appropriate weights to be used were decided as follows:

 

Illustration 3:

The Balance Sheet of Abrasives (Private) Ltd. disclosed the following financial position as on 31st March, 2012:

Illustration 4:

The following particulars are available in respect of the business of Lucky Ltd.:

Illustration 5:

The summarised Balance Sheet of Jai Ltd. as at March 31, 2012 is as follows:

 

Illustration 6:

The balance sheets of X Ltd. are as follows: