Goodwill to Assets Ratio
The ratio of goodwill to assets calculates the proportion of a company's total assets that is made up of goodwill
What is the Goodwill To Assets Ratio?
The goodwill to assets ratio evaluates the percentage of a company’s goodwill compared to its total assets, making it an essential metric to consider when computing the valuation of a company.
Goodwill is a crucial accounting concept that represents a business's intangible value beyond its identifiable assets and liabilities. Goodwill occurs when a company purchases another company at a price exceeding the fair value of its net assets.
Essentially, goodwill represents the worth of a company's reputation, customer connections, brand awareness, and other elements that contribute to its capacity to generate future profits.
It represents the premium for synergies, competitive advantages, and growth potential.
This premium is recorded as goodwill on the acquiring company's balance sheet. Goodwill is classified as an intangible asset subject to periodic impairment testing to determine if its value has decreased.
In order to grasp the importance of the goodwill to assets ratio, one should understand the following:
Goodwill is not amortized like other intangible assets but is subject to an annual impairment test, which involves comparing the reporting unit's fair value, a business segment, or the entire company to its carrying amount, including goodwill.
If the fair value is lower than the carrying amount, an impairment loss is recognized, reducing the value of goodwill on the balance sheet.
To prevent and anticipate such a scenario, analysts routinely compare the company's goodwill-to-assets ratio with industry benchmarks. This helps them determine whether the premium paid is overvalued or not.
This process involves considering market conditions, market trends, and other relevant factors. Note that if an impairment loss is identified, it will be recorded on the income statement, resulting in a reduction of the company's reported earnings.
From an investor's perspective, goodwill to assets ratio provides insights into the strategic value of an acquisition.
Key Takeaways
- The ratio of goodwill to assets calculates the proportion of a company's total assets that is made up of goodwill. It represents the value of the company's intangible assets.
- The ratio plays a crucial role in assessing the value of a company.
- Goodwill impacts the balance sheet by increasing total assets and can affect the income statement if an impairment loss is recognized.
- Companies with high levels of goodwill have an increased risk of impairment and potential write-downs in the future.
Calculating the Goodwill to Assets Ratio?
The goodwill-to-assets ratio compares the goodwill to the total assets of a company. It expresses the value of a company’s intangible assets, such as trademarks, copyrights, patents, trade secrets, brand reputation, customer databases, etc.
Goodwill To Assets Ratio = Goodwill [Purchase price + (Liabilities - Assets)] ÷ Total Assets
There is a particular ratio for each industry. To determine whether the goodwill to assets ratio is typical, the analysts in the company should compare it with benchmarks in the same field.
To understand the goodwill-to-assets ratio, we should seek a valuation method that is not conventional. In other words, intangible assets are to be differentiated from physical ones.
Their worth is based on the client database and reputation and cannot be computed via the accounting rules analysts usually follow when assessing the value of a tangible asset.
An acquisition frequently leads to the creation of goodwill. As we explained previously, it's a premium the buyer is willing to pay for a strategic value.
Interpretation of the Goodwill to Assets Ratio
Tangible assets are more liquid than intangible assets; that’s why having a small ratio or small proportion of goodwill to the enterprise's total assets suggests that the company has more chances of selling its long-term assets, therefore, transforming them into cash.
On the other hand, having a bigger ratio implies that the company may witness a more volatile value of its total assets.
As explained before, intangible assets cannot be valued as physical ones and therefore are more subject to a write-down in case of company business plan changes.
If the proportion of this premium to the newly acquired assets following the acquisition is high, analysts should raise concerns as this can lead to a fragile situation.
In fact, reality can deviate from the business plan because of sales below expectations or lower profit margins.
Consequently, this would indicate that the company that made the recent acquisition has overestimated the premium or goodwill purchased as part of the deal, and therefore, the intangible assets are no longer representative of the current situation.
Accountants will have to write down the portion of goodwill in the balance sheet, thus decreasing the total assets and the company's value.
Example of the Goodwill to Assets Ratio
Goodwill is part of the noncurrent assets in the balance sheet. To compute the ratio, we divide the goodwill by the company’s total assets, equal to non-current assets + current assets. The formula can be expressed as
Goodwill = Liabilities – Assets + Purchase Price
Let's take some numbers in our example below.
Suppose that company A was acquired by company B for $7,000,000. The balance sheet shows that the company's total assets are $5,000,000, and its liabilities are accounted for $1,000,000.
Goodwill = $1,000,000 - $5,000,000 + $7,000,000 = $3,000,000
Goodwill To Assets Ratio = $3,000,000 / $5,000,000 = 60%
This percentage indicates that 60% of company B total assets are linked to the Goodwill generated from the acquisition of company A. Consequently, analysts will deduce from this key performance indicator valuable information such as the company's strategy, financial leverage, and risk exposure associated with the acquisition.
Conclusion
Goodwill plays a significant role in financial reporting and affects the financial statements of acquiring companies. It impacts the balance sheet by increasing the total assets of the company.
Moreover, it can have an impact on the income statement if an impairment loss is recognized. This recognition can result in lower reported earnings and a decrease in the company's overall financial performance.
The goodwill to assets ratio, among others, is a crucial parameter in examining the
financial health assessment, the acquisition analysis, and investor confidence.
Amid mergers and acquisitions planning, this ratio aids in comprehending the extent to which the target company's assets are represented by goodwill.
A small ratio or small proportion of goodwill to the enterprise's total assets suggests that the company has more chances of selling its long-term assets, therefore, transforming them into cash.
If the proportion of the premium to the newly acquired assets following the acquisition is high, analysts should raise concerns as this can lead to a fragile situation.
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