Negative goodwill occurs when one company purchases another for more than it’s worth explains Aron Govil. For example, Company a buys Company B but the fair market value of Company B is less than what Company a paid to acquire it. The difference between what they paid and its fair market value is called negative goodwill because the purchase effectively operates at a loss for Company A.
Negative goodwill is an important concept for investors to understand if they want to learn how much money a company actually makes (or loses). Negative goodwill can be present in companies that show overall profits on their income statement, but it can also present itself when you’re analyzing accounting data to determine the underlying profitability of the business.
What Does Negative Goodwill Mean?
Negative goodwill reflects poorly on management because it may indicate that they paid too much for the company or subsidiary. The purchase may also mean your products are losing market share and becoming less valuable. But, negative goodwill isn’t necessarily bad news. For example, imagine Company a purchased Company B for $100 million dollars but its fair market value was only $80 million. The difference of $20 million is negative goodwill because Company A lost $20 million when the purchase was complete.
However, because Company B has solid assets that are worth at least $80 million this negative goodwill isn’t necessarily bad news for shareholders. In fact, these strong assets come in very handy when Company A goes to pay its next few bills related to the acquisition! Instead of paying cash, Company A can use the assets from Company B because they have a lot more value than what it paid.
The concept is similar with mergers and acquisitions in general. When one company buys another, it may not actually pay all the money up front says Aron Govil. Sometimes companies agree to take on debt or give ownership interests but then end up buying back these interests later. This is why negative goodwill can often present itself in accounting statements when you’re doing an M&An analysis.
Negative Goodwill Example
For example, if Company A wanted to purchase Company B but only had half the money. It may agree to pay $50 million now. But give Company B a 5 year promissory note that has an annual interest rate of 8%. The terms of this promissory note are that Company A must pay the principle plus 40% interest every six months for five years. This means at the end of five years, Company A will have paid back its principle, plus $8 million dollars in interest payments.
Under accounting rules, this principle payment is counted as negative goodwill. Because it was greater than the fair market value of Company B. This negative goodwill amount is counted as an asset on Company A’s balance sheet. Because it effectively extends the period in which Company A must pay off its current liabilities.
Similar to the example above, negative goodwill can often come up when you’re analyzing a business. Due to an M&A transaction or other types of corporate activity. Especially if they involve taking out new debt explains Aron Govil.
Negative Goodwill Affects Balance Sheet
When there is negative goodwill, the net worth on the balance sheet decreases. For this reason, you’ll need to know how to read the notes in annual reports and 10-K filings. So that you understand why assets appear larger than what they paid for them (negative goodwill). Why assets present on the balance sheet are smaller than what they paid for them (negative equity).
Negative goodwill can be good or bad news depending on the situation. Negative goodwill is often associated with M&A activity because it’s common for companies. To take out large loans in order to pay more than the net assets of another company. However, negative goodwill can also reflect poorly on management when they overpaid for an asset. Especially if the purchase doesn’t generate enough revenue to support these additional costs.
Negative goodwill is a non cash charge that happens. When a company pays for an asset or subsidiary more than what it’s worth says Aron Govil. This difference will be accounted for as an asset on the balance sheet and amortized over its useful life. For example, if Company B was purchased from Company a but only had an actual value of $100 million. But they paid $300 million, Company A would have negative goodwill of -$200 million. Which they would count as an intangible asset called “Goodwill”.