The average profit method has widely been used in business valuations, especially in mergers and acquisitions as well as in changing partnerships. From this method, goodwill will be calculated as the average of the profits earned by a given business over several years. This is then multiplied by a certain number of years to find the total value of goodwill. The average profit method is preferred due to its simplicity and fair valuation, though it requires proper application to yield results.
What is Average Profit Method?
The average amount of profit that the business earned over a given period is one of the common methods applied in computing the value of goodwill in a business. Goodwill is an intangible asset that reflects the value a business reaps through its reputation, customer loyalty, and brand strength. In the average profit method of computation of goodwill, the average profit is computed as the total of the profits of a business over a specified number of years, which is divided by the number of years. The average profit obtained is then multiplied by a specific number of years’ of purchase, which is an expression of the expected future profitability of the business.
The average profit method: Key characteristics
- It is a straightforward way of measuring goodwill based on past performance.
- It assumes the anticipation that past profits are a precursor of future performances.
- It therefore follows that the year’s purchase decided upon will make up a material factor in the goodwill value: the amount of time the business may reasonably be expected to produce profits at the current rate.
Example of Average Profit Method
To better understand the average profit method, let’s consider a practical example:
Example:
A business has made the following profits over the last five years:
- Year 1: $50,000
- Year 2: $55,000
- Year 3: $60,000
- Year 4: $52,000
- Year 5: $58,000
To calculate goodwill using the average profit method, follow these steps:
1. Calculate the Total Profit:
50,000+55,000+60,000+52,000+58,000=275,000
2. Find the Average Profit:
Average Profit= 5 / 275,000 =55,000
3. Determine the Goodwill:
Assume the number of years’ purchase is 3. Multiply the average profit by the number of years’ purchase:
Goodwill=55,000×3=165,000
Thus, the goodwill of the business, using the average profit method, is valued at $165,000.
This example illustrates the simplicity of this method, where historical profits are used to estimate the business’s value based on expected future profitability.
Usage of Average Profit Method in Goodwill
The average profit method is the most frequently used in the calculation of goodwill during the analysis of the value of a business in the event of merger and acquisition or admission/retirement of a partner. Goodwill is considered an intangible, though valuable, asset as it represents one’s ability to earn profits that are above average on account of reputation, location, and customer base, among others. The average profit method finds application, particularly when the business can demonstrate a reliable record of profitability.
Why Use the Average Profit Method?
Easy Calculation
It requires only historical profit figures and an assumption about the number of years’ purchase. The method is quite easy to apply.
Reflective of Past Performance
This approach offers thorough proof of the firm’s past earning capacity, a bit that has been known to well become an excellent predictor of future performances as it forms the basis of the valuation on average past profits.
Commonly Used in Small and Medium-Sized Enterprises (SMEs)
The average profit method is often applied in smaller businesses where the goodwill is directly linked to consistent profit-making abilities.
Goodwill in Partnership Firms
The average profit method is the most frequently used method of goodwill valuation when there is either retirement or admission of a new partner to the partnership. It guarantees that the incoming or outgoing partner either receives or pays the proper value based on the historical profitability of the business.
Limitations
This method has limitations because it may not take into account the fast-changing markets, business conditions, or any unique events that might have affected the profits in the past. It merely assumes that future earnings are mainly going to be as good as earnings in the past.
How Do You Calculate Profit Average?
To calculate the profit average for the average profit method, follow these simple steps:
1. Accumulate Historical Profits: Collect profits from the business for a period of years, usually 3 to 5 years.
2. Add Total Profits: This step is an addition of profit numbers for all the chosen years to get the total amount of profit.
3. Divide by Number of Years: Divide the total profit by the number of years for the average profit.
4. Multiply by Years of Purchase: The above-calculated average profit is then multiplied by the chosen number of years’ of purchase. The number of years purchased is the number of years that the anticipated profits can be expected to continue.
Formula for Average Profit Method
Example:
If a business earned total profits of $250,000 over five years and the years’ purchase is 4, the calculation would be:
– Total profit: $250,000
– Average profit: $50,000
– Goodwill = $50,000 × 4 = $200,000
This straightforward formula allows for quick and easy goodwill valuation, provided there is a consistent and reliable profit history.
Can the Average Profit Method Be Applied to Any Business?
The most common, however, is the average profit method. Though it can’t be applied to all businesses, this method best suits those firms that portray a systematic and consistent pattern of profits over time. Here are some requirements for when this average profit method is correct:
Applicable Businesses
- Small and Medium-Sized Enterprises (SMEs): The average profit method is frequently applied to small businesses, retail stores, or service providers with consistent profit histories.
- Stable Businesses: This method works well for businesses with relatively stable revenues and profits, where past performance is a reliable indicator of future performance.
Non-Applicable Businesses
- Startups: For businesses in their early stages or startups, this method is not suitable because they may not have a significant profit history, and future profits are highly uncertain.
- Businesses with Volatile Profits: This method can’t help much for companies that often lose profits because of market conditions, business cycles, or incidental events. Other valuation methods will probably be more suitable in those cases, like the super profit method or the discounted cash flow method.
Conclusion
In such cases where the history of profit for a business is stable and certain, the average profit method can be very helpful in determining the goodwill of a business. It, therefore, offers a simple way of valuing the intangible assets of a business based on the facts gathered from its past performance. This method is widely applied especially to small and medium enterprises, but it may not work for all businesses, especially those with volatile profits or a limited operational history. Understanding how to calculate the average profit and when to apply this method allows the business owner, investor, and partner to make more informed decisions in deciding the business valuation.
Average Profit Method FAQs
What is the average profit method?
The average profit method is used to determine a business’s goodwill by taking the average of its profits over a specified period and multiplying it by the number of years’ purchase.
Is the average profit method applicable for any business?
No, the method is most suitable to business concerns with stable and consistent profit histories. It is not ideal for start-ups or concerns with volatile profits.
How do you arrive at the average profit?
The total profits over a particular number of years, say 5 years are added up and divided by the number of years. This result is multiplied by the years’ purchase to arrive at goodwill.
What is the purpose of years’ purchase in the average profit method?
The number of years’ purchase represents the future period over which profit is expected to continue at the current rate. It directly affects the value of goodwill calculated.
What are the disadvantages of the average profit method?
The average profit method may not be an accurate reflection of future profitability if market conditions change substantially or if the company’s history of profits is very volatile.
