1. Terminology Before the Methods
| Term | Meaning |
|---|---|
| Average Profit | Simple average of profits over a number of years = Total Profits ÷ Number of Years. Used as the baseline earnings estimate. |
| Weighted Average Profit | Average that assigns higher weights to recent years (recent profits are better predictors). = Sum of (Profit × Weight) ÷ Sum of Weights. |
| Normal Profit | Expected profit at the normal rate of return for the industry on the capital employed. = Capital Employed × Normal Rate of Return. |
| Super Profit | Excess of actual average profit over normal profit. = Average Profit − Normal Profit. This is the foundation of the business's goodwill. |
| Years' Purchase (YP) | Multiplier indicating for how many years the buyer is willing to pay for the profits. Given in the problem. |
| Capital Employed | Net Assets = Total Assets − Outside Liabilities. Or: Capital + Reserves (from liability side). Used as the base for calculating normal profit. |
2. Method 1 — Average Profit Method
Two variants:
- Simple Average: Equal weight to all years. Used when profit trend is stable.
- Weighted Average: Higher weights to recent years. Used when recent profits are more representative.
Adjustments to Profit Before Calculating Average
- Add back: Abnormal losses (fire loss, flood damage — not expected to recur)
- Deduct: Abnormal gains (sale of asset at profit — not expected to recur)
- Deduct: Non-recurring income (windfall, speculation profit)
- Add back: Non-recurring expenditure (extraordinary legal charge)
- Deduct: Notional salary of working partner (if not already charged)
- Deduct: Interest on capital (if not already charged)
Worked Example — Simple Average
Profits for 5 years: ₹50,000; ₹60,000; ₹55,000; ₹65,000; ₹70,000. Years' Purchase = 3.
Average Profit = (50,000 + 60,000 + 55,000 + 65,000 + 70,000) ÷ 5 = 3,00,000 ÷ 5 = ₹60,000
Goodwill = ₹60,000 × 3 = ₹1,80,000
Worked Example — Weighted Average
Same profits, weights: 1, 2, 3, 4, 5 (latest year gets highest weight).
| Year | Profit (₹) | Weight | Product (₹) |
|---|---|---|---|
| 1 | 50,000 | 1 | 50,000 |
| 2 | 60,000 | 2 | 1,20,000 |
| 3 | 55,000 | 3 | 1,65,000 |
| 4 | 65,000 | 4 | 2,60,000 |
| 5 | 70,000 | 5 | 3,50,000 |
| Total | 15 | 9,45,000 |
Weighted Average Profit = 9,45,000 ÷ 15 = ₹63,000
Goodwill = ₹63,000 × 3 = ₹1,89,000
3. Method 2 — Super Profit Method
Worked Example
Capital Employed = ₹4,00,000; Normal Rate = 10%; Average Profit = ₹60,000; Years' Purchase = 3.
Normal Profit = 4,00,000 × 10% = ₹40,000
Super Profit = 60,000 − 40,000 = ₹20,000
Goodwill = 20,000 × 3 = ₹60,000
4. Method 3 — Capitalisation of Average Profit
Logic:
If the business earns ₹60,000 per year and the normal rate is 10%, then the capital that would be required in a normal business to earn ₹60,000 is ₹60,000 ÷ 10% = ₹6,00,000. If the actual capital employed is only ₹5,00,000, then the firm has ₹1,00,000 of "extra" value — which is goodwill.
Worked Example
Average Profit = ₹60,000; Normal Rate = 10%; Actual Net Assets = ₹5,00,000.
Capitalised Value = 60,000 ÷ 10% = ₹6,00,000
Goodwill = 6,00,000 − 5,00,000 = ₹1,00,000
5. Method 4 — Capitalisation of Super Profit
Logic:
Goodwill is the capitalised value of the stream of super profits — treating the super profit as a perpetual annual return.
Worked Example
Super Profit = ₹20,000; Normal Rate = 10%.
Goodwill = 20,000 ÷ 10% = ₹2,00,000
Comparison of All Methods
| Method | Based on | Formula | Goodwill (example) |
|---|---|---|---|
| Average Profit | Total profits | Avg Profit × YP | ₹60,000 × 3 = ₹1,80,000 |
| Super Profit | Excess over normal | Super Profit × YP | ₹20,000 × 3 = ₹60,000 |
| Capitalisation of Avg Profit | Total value − Assets | Avg Profit/Rate − Net Assets | ₹6,00,000 − ₹5,00,000 = ₹1,00,000 |
| Capitalisation of Super Profit | Perpetual excess earnings | Super Profit / Rate | ₹20,000 ÷ 10% = ₹2,00,000 |
