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Goodwill: Nature and Valuation — Part 2: Capital Employed, Super Profit and Capitalisation

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Lesson

Capital employed, super profit and capitalisation

Part 2 — normal profit, capital employed, the super profit method and the two capitalisation methods.

In this lesson you will

Compute capital employed from a balance sheet, leaving out goodwill, non-trade investments and fictitious assets
Value goodwill as a number of years' purchase of super profit
Value goodwill by capitalising average profit and by capitalising super profit, and explain why the two agree

Part 2 at a glance

Concept

Normal rate of return and normal profit

Table of four terms: the normal rate of return earned by similar firms, capital employed as net assets used in the business, normal profit as capital employed times the normal rate, and super profit as average profit minus normal profit
Term	Meaning	Formula
Normal rate of return	Rate that similar firms in the same trade usually earn on capital	Given in the question
Capital employed	Net assets used in the business	Assets used − outside liabilities
Normal profit	Profit an ordinary firm would earn on the same capital	Capital employed × normal rate ÷ 100
Super profit	Profit above the normal profit	Average profit − normal profit

Concept

Capital employed (net assets)

Capital employed = assets used in the business − outside liabilities.

Table of what to leave out when computing capital employed: existing goodwill, non-trade investments and fictitious assets are excluded from assets, and outside liabilities such as creditors, bills payable, loans and outstanding expenses are deducted
Leave out of assets	Why
Goodwill already in the books	It is the very thing being valued
Non-trade investments	Not used in the business (their income is also removed from profit)
Fictitious assets (debit balance of Profit and Loss, deferred revenue expenditure)	No realisable value
Then deduct outside liabilities	Creditors, bills payable, loans, outstanding expenses