What is the purpose of Goodwill?

Goodwill company example

Balance sheets contain a number of terms that are not always well understood, and one of those terms is known as 'Goodwill'. Goodwill is an intangible non-current asset that arises as a result of an acquisition, but it is inherently a figure that can distort a company's asset backing and even lead to significant 'exceptional' costs/profits arising over time. This tutorial will look at what exactly goodwill is, an example of where it arises, and why it can be problematic for a company in the years after it is created.

What is goodwill?

As noted above, goodwill is a type of intangible asset. That means it is not an asset you cannot touch, unlike a car or building. When does it arise? It arises when a company purchases another company and pays a price that is a premium to the net book value of the company. It is that premium that goes on to form goodwill. As a numerical example, if you purchase a company with a net book value of £50m for £70m, then a £20m goodwill line will be created as a non-current intangible asset on your balance sheet.

Although the actual goodwill calculation can be particularly complex given that this is an accounting term, an example is shown below. This represented the goodwill calculation when Glencore (LSE:GLEN) purchased mining company Xstrata, to form Glencore Xstrata.

In fact, you can actually have negative goodwill. This occurs when you purchase a company at a value less than its net book value.

The problem with goodwill

The problem with goodwill is all to do with its actual definition. If you purchase a price for a company 1000% above its net book value, then you are probably overpaying for that company. Yet, you get an intangible asset on your balance sheet replicating that asset size.

In other words, if you purchase a company of £100,000 when its net book value is only £2,000, then you will have goodwill on your balance sheet of £98,000 as an asset. An asset is supposed to be something 'good', yet all this goodwill asset says is that we have grossly overpaid for the company and it's potentially not really an asset at all. This is why some investors seek to find the Net Tangible Asset Value (NTAV) of a company. Since goodwill is intangible, it is excluded from this calculation.

Of course, its not that straightforward. For example, due to accounting rules, internally generated brands cannot be shown on a company's balance sheet, yet these can be incredibly valuable. These are therefore implicitly shown in goodwill upon a takeover.

This goodwill figure is periodically tested for impairment. That means that, even so often, it is checked to see whether it still accurately reflects the value that it shows. If the value of the company acquired has drastically reduced, then you may proceed to impair the asset. This involves reducing its goodwill value and putting that writedown as a cost on the income statement, which can create a significant loss for the period.

An Example: Premier Foods (LSE:PFD)

For example, Premier Foods conducted a significant goodwill writedown on one of its businesses in 2014/15 after the value of those assets fell.

You can see on the income statement that this is reflected in a large non-recurring cost that shows what would have been a sizeable operating profit turned into a large operating loss.

However, goodwill impairment is a non-cash charge; there is no cash outflow associated with it. It is also based on historic events (acquisitions), so you would normally add this back to uncover the real operating performance of the business. Reversing the impairment we would find that the operating profit of Premier Foods for this period was actually -£44.1m + £83.9m = £39.8m. We can therefore see that a goodwill impairment can lead to a major distortion of financial results.

Indeed, one of the largest corporate losses in history was down to a goodwill impairment after AOL Time Warner wrote down the value of America Online after the internet bubble burst. The impairment totalled $54 billion, which is approximately equal to the entire size of mining giant Glencore Xstrata (LSE:GLEN), or is equal to the size of Marks & Spencer (LSE:MKS), Smith & Nephew (LSE:SN.) and International Airlines Group (LSE:IAG) combined. (valid 27/06/15).