Goodwill to assets ratio is a metric that indicates the percentage of a business assets that is comprised by goodwill paid for assets acquired above their historical or market value. It is also an indication if the company has been buying other companies as part of its growth strategy, as the goodwill account records the premium paid on the book value of such purchases.
What is Goodwill to Assets?
Contents
The goodwill account became increasingly popular since taking over other firms became a standard practice. Companies that want to grow their businesses faster and have the resources to do so will rather acquire an existing business with a solid business model than create a new one from scratch to enter a certain market.
The popularity of this practice started to have an impact on companies Balance Sheet’s, as the goodwill account increased significantly, due to the premiums paid on the acquired shares. As a result, some companies have a significant portion of their assets tied to goodwill, which is an intangible asset. Goodwill is, nevertheless, not an stable asset, since it is derived from the business’ valuation of the firms it acquires, and these purchases may turn out to be less valuable than they should, which will lead to a write-off in the value of the goodwill and subsequently, a reduction in the asset base of the acquirer.
Goodwill to Assets Ratio Formula
The formula to calculate the Goodwill to Assets metric:
Goodwill to Assets = Goodwill / Total Assets
Goodwill to Assets Ratio Equation Components
Goodwill: The amount of goodwill reflected in the company’s Balance Sheet.
Total Assets: The sum of all current, fixed and other assets.
The result is expressed as a percentage of the total assets.
Goodwill to Assets Example
Royal Powder is a company that produces baking flour, powder and other minor ingredients for bakery. The business is huge, with annual sales of more than $600 million. Recently, the management team has been studying the possibility to expand to other segments of the bakery market such as the instant baking segment. In order to step into this market, they can either launch an in-house project to build the product line from scratch or they can just acquire a company that is already in the market.
The management team decided this was the cheapest and possibly the most likely to succeed scenario and they are currently aiming at Momma Carla Bakery Products LLC, a business with a significant market share and a great reputation among consumers.
Royal Powder’s current goodwill account is $32,450,000 from past acquisitions and according to the legal team advising them on this deal Momma Carla’s business has a book value of $143,000,000 and the price offered for the entire business was $187,000,000, which results in a $44,000,000 goodwill. The company’s current total assets are $379,000,000.
As a result, Royal Powder’s goodwill account will end up at $76,450,000 and total assets for the business will be at $423,000,000. The goodwill to assets metric before and after the acquisition can be calculated as follows:
Goodwill to Assets (before) = $32,450,000 / $379,000,000 = 8.6%
Goodwill to Assets (after) = $76,450,000 / $423,000,000 = 18.0%
Goodwill to Assets Ratio Analysis
There are two basic ways to grow a business. One way is to grow it organically, by expanding product lines, markets, geographical reach and production capacity, or it can also be grown inorganically, by acquiring other firms that are already in business, in order to cut corners and grow. The Goodwill to Assets metrics gains importance if the company being analyzed has been consistently acquiring firms as part of its growth strategy, as it measures how much of the company’s assets are backed by the premiums paid on these businesses that will supposedly increase the firm’s overall value and profitability.
A high ratio indicates that the business’ assets are heavily backed by goodwill, which is a risky situation to be in from an investor’s standpoint, since this goodwill may result from deals that were overpriced and the value brought by the acquired businesses may turn out to be much less than expected, which will lead to a write-off (a total or partial discharge of the goodwill paid on the business), which will eventually drive the total assets down and therefore, the value of the business’ shares as a whole.
A high ratio could also come from the write-down of current tangible assets. For example, a plant whose book value appears to be overly exaggerated compared to the current market value of a plant in its exact conditions has to be written down to show an accurate value in the fixed assets account. Later on, this write-down will eventually be passed to the income statement in the form of a loss.
In turn, a firm that decides to grow its business organically may reflect little to no value in the goodwill account, therefore its Goodwill to Assets ratio will be low. By rule of thumb, any company with a Goodwill to Assets ratio higher than 30% should be carefully analyzed to make sure the risk of potential write-off is low.
Goodwill to Assets Uses, Cautions, Pitfalls
The goodwill item comes from the difference between the total price paid for the acquired business and the actual book value of its equity. If the acquirer pays a large premium on the book value, the goodwill item will end up inflating the acquirer’s assets artificially and it will make the company look bigger and stronger than it may be.
This is a particular reality of today’s corporate world, where many acquisitions are made on a daily basis and in some instances the acquisition are made based on strategic moves and not in financially sound transactions. If the price paid to purchase a business is not backed by sound financial analysis, the result may be that the transaction was overpriced and therefore the goodwill item may be overvalued, which will eventually create the need for a write-off.
For this reason, the Goodwill to Assets ratio plays an important role in evaluating a firm’s asset base. If the ratio is too high, it should be considered as a warning signal that further scrutiny may be a good idea, to verify the goodwill account’s value is backed by sound financial decisions.