Is Business Goodwill something a small business owner should be concerned with? I would say, without hesitation, absolutely yes. Not only does it add to the value of your business but if used appropriately, it becomes part of a tool to manage your business.
Most Accountants define Goodwill as a part of your business value that is above what your normally identifiable assets are. When calculated it is simply a subtraction of fair market value of the business’s tangible assets from the total business value. An Economist would look at Goodwill as the value of business earnings that exceed the return on all other business assets. The International Glossary of Business Valuation Terms defines goodwill as “that intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.” The latter is the definition I use.
One major component of business goodwill is the value derived from repeat customers. Achieving strong customer retention rates is a critical component of any business’s success and should be a measured and monitored business function. If the business isn’t retaining its customers then obviously the business is not sustainable, as customer sustainability is important to revenue stability. Simply focusing on sales is not sufficient, the business must focus on revenue from new sales and revenue from retained customers. The combined force of sales to new first-time customers and sales to existing customers is essential to business growth and survival. If either one slips, the business will most likely flounder or fail.
As a result, the economic value of customer retention, and the corresponding strategic value of customer service, is a large component of determining business goodwill.
Calculating business goodwill is normally done in any one of three different ways:
The simplest method is using average profits. The business owner simply averages profits over a selected period of time, then multiplies that average by the number of years considered. While the most common of ways to calculate business good will, it requires manipulation of the profit and loss calculations before determining average profit and business goodwill.
Another method is the Super Profit method. This is nothing more than using the profits earned over normal profits. So if your average profits in your Small Business is $100,000 and this year you earn $125,000, then your good will is $50,000.
The third method is a bit more complex and involves capitalizing profits. This involves using either the average profit, super profits, assets, liabilities and a normal rate of return on investments. In short, this method determines goodwill as the difference between a normal rate of return and the current rate of return for the business.
When I work with Small Business Owners in growing their business, improving profitability, achieving lending eligibility and so on, I use a hybrid that considers some of the issues above but mostly focuses on the actual value of new and existing clients. Through my method, I determine the economic value to the business, of its customers. Ultimately this calculation considers the time value of customers over a defined period and matched to revenue from those customers, to determine a dollar value for goodwill. This calculation also allows us to determine the rate of erosion or growth of that economic value.
While not the defining metric of a business valuation, Goodwill, when factored with assets and liabilities, determines an overall economic value for the business owner. When these calculations are interpreted by the business owner, they can assess where they need to focus their efforts, initially, to improve business value. Consequently, the use of goodwill becomes a significant tool for the business owner to use in growing their business.
I would encourage all Small Business owners to pay attention to the economic value of Goodwill to their business. Understanding this creates significant value added for your business while providing you with a strong tool for ensuring business stability and growth.