As you’re working hard to grow your business, you’ve likely heard the term “goodwill” in accounting. It’s a term that you probably feel like you should know, but maybe you find it hard to define.
Goodwill accounting relates to small businesses that have been or are being acquired. That’s because it involves the business’s value, yet that number alone isn’t an accurate representation of how much a business is worth.
In this guide, you’ll learn what goodwill is, how it affects your business finances, and how it impacts your business’s operational and exit plans.
Why does goodwill matter?
Goodwill is a complex concept that’s tough to define, so it’s better to first review it through a primer to understand its importance.
Goodwill is one of your business’s assets, but it has some caveats. Your business will only have goodwill if it’s been bought out by someone or another business. In other words, it will only be on your balance sheet after you or someone else has bought your business.
Similar to other assets, a portion of your goodwill asset can be written off as an amortization expense, and it can be written off in 10 years. Unlike other assets, goodwill has no tangible value until the business is sold again. While you can easily sell your business’s equipment, furniture, and inventory, you can’t sell your goodwill unless it’s part of selling your business.
What is goodwill?
Goodwill is an accounting term that refers to information on your business’s balance sheet. In the simplest words, goodwill is a business asset that represents the amount paid to buy a business above the fair market value cost of all its assets or the premium that was paid for an acquisition above its tangible assets.
To understand why you would report goodwill, it’s important to have a refresher on your balance sheet:
- Your balance sheet is your most important financial statement as it tracks your business’s cumulative performance.
- All the information on the balance sheet makes up your book value. This means that assets are reported at their cost, not their market value. For example, inventory is reported at the cost to make and acquire that inventory, not its market value.
- Unsurprisingly, your balance sheet needs to actually balance out! Any business transaction has to affect at least two parts of the balance sheet to keep it in balance.
Here’s how goodwill fits into the equation. Imagine the simple example below where a business has $100,000 in cash, inventory, and equipment, and the owners have cumulatively invested $100,000 into the business. The balance sheet would look like this:
| Seller’s Balance Sheet (Before Sale) | |
| Assets | |
| Cash, Inventory, Equipment | $100,000 |
| Debts | |
| No Debt | $0 |
| Equity | |
| Investment | $100,000 |
An investor has come along and wants to buy the whole business for $300,000. You might say, “Wait a minute, why is this person willing to pay $300,000 for a business with assets of $100,000?” It’s because the balance sheet only shows the value of cash and the cost of its inventory and equipment. These numbers can be far from what a business is truly worth.
Because the balance sheet must stay balanced, it needs a special fix. When the business is bought out, the investment increases by $200,000 (going from $100,000 under the old owner to now $300,000), but there isn’t any increase in cash in the business’s bank account to balance out that transaction. So, an additional asset called “goodwill” is created to capture the new value of the business now that it’s worth $300,000.
| Buyer’s Balance Sheet (After Sale) | |
| Assets | |
| Cash, Inventory, Equipment Goodwill | $100,000 $200,000 |
| Debts | |
| No Debt | $0 |
| Equity | |
| Investment | $300,000 |
This is why goodwill is an intangible asset. In the short term, it’s merely an accounting entry. It doesn’t have any value during day-to-day operations. The only time goodwill will have a financial impact is when the business is sold again or if you close it.
What’s the impact of goodwill accounting?
Goodwill impacts how you use your balance sheet to manage your operations. It’s good practice to use your balance sheet every month as a management tool. It will guide you on how to build up your business’s net worth and clearly see how much “equity” is available for you to pay out as an owner’s distribution.
If your business is making a profit and has positive equity (meaning you have more assets than debts on your balance sheet), then some portion of that equity can be paid out to you and any other owners.
But when your business has goodwill, it can throw off this simple analysis.
Goodwill can skew the equity that’s reported on your balance sheet. In these cases, it’s best to also pay close attention to your working capital.
Working capital is your current assets minus your current liabilities, and it offers insights into your business’s liquidity and operational efficiency. It essentially measures your ability to meet your business’s short-term obligations with your liquid assets, while also considering your long-term debt obligations.
By examining both equity and working capital together, investors can gain a more comprehensive understanding of your business’s financial stability and growth prospects.
You can review your balance sheet as if the goodwill isn’t there, subtracting it out like in this example:
| Assets | With Goodwill | Without Goodwill |
| Cash, Inventory, Equipment Goodwill | $50,000 $100,000 | $50,000 |
| Debts | ||
| Business Loan | $40,000 | $40,000 |
| Equity | ||
| Net Equity Net Equity Less Goodwill | $110,000 | $10,000 |
In this case, looking at the balance sheet without any changes would lead you to believe that the business has plenty of equity and can pay out a large distribution to its owners. But when you factor out goodwill, it’s clear that there are less funds available.
After doing this quick calculation, the business has just $10,000 in equity available for distributions – far less than $120,000 originally listed. This is a good analysis to conduct for your daily operations because goodwill’s value isn’t guaranteed until you successfully sell your business again.
If you bought a business and it now has $100,000 in goodwill, that goodwill will only have real value again if and when you resell it. In the meantime, you could actually be dipping into loan funds to finance your ongoing operations, which is something you want to avoid.
Goodwill also impacts your tax and financial situation when you resell your business. Accurately recording your goodwill can help you limit your capital gains tax, which are taxes on the difference between what you paid for an investment and how much you received when you sold it.
For example, let’s say you sell your business for $300,000 and prove that you paid a full $200,000 to buy it. Having proper recordkeeping for goodwill means you’ll only pay capital gains taxes on the $100,000 you earned from the sale. If you don’t have good recordkeeping for goodwill, you may need to pay capital gains taxes on a larger amount.
Goodwill accounting and business loans
Lenders are typically willing to give loans that are secured by tangible assets such as inventory, accounts receivable, equipment, and real estate. They’re more hesitant to approve a loan when you’re leveraging your business’s goodwill as collateral.
What’s the reason behind this hesitation?
Goodwill is an intangible business asset that comes from elements like brand recognition, prestige, customers, geographic positioning, and other elements that aren’t easily quantifiable.
This poses challenges when you want to use it as collateral for a business loan. Unlike tangible assets, a lender can’t repossess goodwill if the loan isn’t repaid. However, if you decide to sell your business, goodwill can be converted into a tangible asset: cash.
When you’re looking for a loan, talk with potential lenders about acceptable collateral types so you’re prepared before you apply.
Pursuit has loan options and resources to keep your business growing
Goodwill symbolizes the premium amount a buyer is willing to invest in a lucrative business with bright prospects ahead. It shows how much your business is worth from a buyer’s perspective beyond the combined value of your tangible assets.
To keep your business growing and increase its value, you may need funding and resources to take on new opportunities. That’s where Pursuit can help! We offer more than 15 different business loan options for nearly any need to keep you moving upward and onward. Reach out to us today to learn more about what’s possible.
