Capitalization Method

Under Capitalization Method, goodwill of a firm can be calculated by either of the following two ways.

  • Capitalization of Average Profit
  • Capitalization of Super Profit

Capitalization of Average Profit

Under this method, first of all the capitalised value of the business is calculated. This value is calculated by capitalizing the average profit on the basis of the normal rate of return of a business. To calculate the value goodwill of the firm the actual capital employed of a firm is deducted from the value of the business so calculated.

Therefore,the formula for calculating goodwill by this method is Godwill = Capitalized Value of Average Profit – Actual Capital Employed

Steps to Calculate Goodwill by Capitalization of Average Profit Method

Step 1: Calculate the average profit of the firm.
Step 2: Calculate Capitalised value of Average Profit on the basis of normal rate of return by the following formula.
Step 3: Ascertain Actual Capital Employed of the firm.
Capital Employed = Total Assets (other than fictitious assets) – External Liabilities
Step 4: Deduct Actual Capital Employed from the Capitalised value of Average Profit to compute the value of goodwill.
Goodwill = Capitalised Average Profit – Actual Capital Employed

Capitalization of Super Profit

Under this method, goodwill is calculated by capitalising the super profits of the firm. It means under this average profit is calculated but instead of capitalisation of average profit, capitalising of super profit is done.

The formula for calculating goodwill by this method is Goodwill = Super Profit * ( 100 divided by Normal Rate of Return)

Steps to Calculate Goodwill by Capitalization of Super Profit Method

Step 1: Calculate Capital Employed of the firm as:
Capital Employed = Total Assets – External Liabilities
Step 2: Calculate Normal Profit of the firm as:
Step 3: Calculate Average Profit.
Step 4: Calculate Super Profit of the firm by deducting Normal Profit from Average Profit, as:
Super Profit = Average Profit – Normal Profit

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