The goodwill to assets ratio measures the amount of goodwill a company has recorded on its books compared to its total assets. Therefore, the goodwill/assets ratio is used to determine what portion of a company’s assets are classified as intangible assets versus its tangible assets.
What is Goodwill?
Goodwill is an intangible asset that arises when a firm purchases another firm at a premium value. Under accounting standards such as US GAAP and IFRS Standards, goodwill need not be amortized but needs to be evaluated for impairment yearly.
It is important to note that goodwill cannot be generated internally – IFRS 38 does not allow recognizing internally generated goodwill. Therefore, goodwill is only generated through purchasing other firms and is determined as the excess purchase price over the acquiree’s book value.
Goodwill = Liabilities – Assets + Purchase Price
For example, consider a firm purchasing another company for $250,000. The acquiree owns total assets of $360,000 and liabilities of $150,000, resulting in net assets of $210,000. Therefore, the goodwill generated in this purchase would be:
Company B’s owner is looking to sell their company to a purchaser, Company A, and is asking for $100 million. Company B is a strong player in the semiconductor industry, with a strong brand reputation, customer lists, and a strong market position.
Company A understands that they would be paying a premium for Company B and therefore wants to determine approximately how much of the purchase price would go towards paying for goodwill. Company B’s book value, according to their most recent financial statements, is $80 million with zero debt on the books.
In the transaction above, we are given the following information:
Sale price: $100 million
Total assets: $80 million
Unamortized goodwill: $100 million – $80 million = $20 million
Plugging in the information to the goodwill to assets formula:
The resulting ratio indicates that 20% of Company B’s valuation comes from its goodwill. Therefore, for the purchase price of $100 million, 20% of it would go towards paying for goodwill.
Interpretation of the Goodwill to Assets Ratio
The goodwill to total assets ratio presents a better idea of a company’s financial standing. To reiterate, the ratio measures the amount of goodwill that a company owns in relation to its total assets. The higher the ratio, the higher a company’s proportion of goodwill is to total assets.
A smaller ratio indicates that a significant portion of a firm’s total assets is comprised of tangible assets – physical assets that can be sold for monetary value.
A larger ratio indicates that a smaller portion of a firm’s total assets is comprised of tangible assets. In such a case, the valuation of a firm with a large amount of goodwill can swing heavily if the firm’s goodwill is written down.
As with other financial ratios, a suitable goodwill/assets ratio varies by industry – it is ideal to compare ratios within industries and on a trended basis.
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