Average Profits Method
Learn how to calculate goodwill using average profits - made simple for students!
Two Types (a) Simple Average Profits Method b) Weighted Average Profits Method
What is Simple Average Profits Method?
The Average Profits Method is used to calculate the goodwill of a business. Goodwill represents the future earning potential of a business based on its past performance.
Simple Average Profit = Total Profits / Number of Years for which profits taken
Let's Start with a Simple Example
Imagine a business has the following profits for 3 years:
| Year | Profit (₹) |
|---|---|
| 2022 | ₹1,00,000 |
| 2023 | ₹2,00,000 |
| 2024 | ₹30,000 |
| Total | ₹3,30,000 |
Average Profit = ₹3,30,000 ÷ 3 = ₹1,10,000 per year
This means the business can potentially earn ₹1,10,000 every year in the future!
Understanding Goodwill
When you buy a business, you're essentially buying its future profits in the form of Goodwill.
So we multiply average profits per year (calculated earlier) with the number of years, for which we are purchasing the profits
This is called "Number of Years Purchase".
The number of years purchase is usuallygiven in question.
If Number of Years Purchase = 3
Different Ways to Express number of years purchase
- 2 years = 2 times = 200%
- 3 years = 3 times = 300%
- 4 years = 4 times = 400%
Understanding Financial Years
For Goodwill calculation, we find average profits for previous 3 to 5 financial years
Questions can present financial years in different formats. Here's how they're written:
| Method 1 | Method 2 | Method 3 | Method 4 |
|---|---|---|---|
| 01-Apr-2024 to 31-Mar-2025 | Year ending 31-Mar-2025 | 2024-2025 | 2024-25 |
| 01-Apr-2023 to 31-Mar-2024 | Year ending 31-Mar-2024 | 2023-2024 | 2023-24 |
All these formats mean the same thing - just different ways of writing financial years!
Calculating normal adjusted business profits
Let's Learn this with an example of a student. Imagine you're in Class XI and missed final exams due to fever. Your teacher will give marks based on average of marks in previous classes:
Marks in previous classes were
| Class | % Marks | Note |
|---|---|---|
| IX | 70 | 10% less due to accident in final exams |
| X | 80 | Normal performance |
| XI | 82 | Good performance |
Adjusted Average: (80 + 80 + 82) ÷ 3 = 80.67%
Why adjust? The accident in Class IX was abnormal - it doesn't reflect your true potential!
Why adjust? We are calculating future marks based on past marks. Past Marks just gives an idea.
Why adjust? We have to adjust for new events in future or remove impact of past events not likely to happen in future
Adjustments in Business Profits
Just like the student example, we need to adjust business profits for abnormal items:
Average profits is calculated only after making the below adjustment to past years profits
Each point explained in a separate article
🔻 DEDUCT (Less)
- Abnormal income or gains( Example - insurance claims)
- Profit on sale of fixed assets
- Non-business income
- Partner salary or remuneration/Management Cost
- Overvaluation of closing stock
- Undervaluation of opening stock
- Income in past but not expected to arise in future (Non recurring income)
- Expenses not in past, but likely to arise in future
🔺 ADD (More)
- Abnormal losses (fire, theft, accident)
- Loss on sale of fixed assets
- Undervaluation of closing stock
- Overvaluation of Opening Stock
- Expenses in past but not expected to arise in future (non recurring expenses)
- Income not in past but likely to arise in future
Weighted Average Profits Method
Simple average method treats all years equally
But recent years are more important for predicting future!
Example for Weighted Average profit method
For explanation and steps see next slide
| Year | Profit (₹) | Adjustment (₹) | Adjusted Profit (₹) | Weight | Weighted Value |
|---|---|---|---|---|---|
| 2022 | 80,000 | +20,000 | 1,00,000 | 1 | 1,00,000 |
| 2023 | 1,45,000 | -25,000 | 1,20,000 | 2 | 2,40,000 |
| 2024 | 1,60,000 | -15,000 | 1,45,000 | 3 | 4,35,000 |
| 2025 | 2,00,000 | 0 | 2,00,000 | 4 | 8,00,000 |
| Total | 10 | 15,75,000 | |||
If Years Purchase = 2, then Goodwill = ₹1,57,500 × 2 = ₹3,15,000
Step-by-Step Process for Weighted Average
When to Use Which Method?
Simple Average Method
- When question asks for it
- When question is silent about which method to use
- When profits show no clear trend
Weighted Average Method
- When question specifically asks
- When profits show clear upward trend (Profits increasing every year)
- When profits show clear downward trend (Profits decreasing every year)
| Year | Uptrend Example | Downtrend Example | No Trend Example |
|---|---|---|---|
| 2021 | ₹1,00,000 | ₹5,00,000 | ₹5,00,000 |
| 2022 | ₹1,25,000 | ₹4,00,000 | ₹6,00,000 |
| 2023 | ₹1,35,000 | ₹3,50,000 | ₹4,00,000 |
| 2024 | ₹1,40,000 | ₹2,50,000 | ₹20,000 |
Key Takeaways
Goodwill = Average Profit × Number of Years Purchase