Applying the moniker "goodwill" to something that can be as crippling to a company's financial stability as a toxic debt instrument seems a little strange. A better name would be "mystery asset" -- because at least that way, unsophisticated investors would be less likely to skim over it on financial statements, thinking it's somehow tied to places where you donate old clothes to charity.

Goodwill writedowns have wreaked havoc on income statements and balance sheets across many sectors in multiple markets. Knowing more about goodwill can benefit all market participants -- and understanding their implications can prevent you from making mistakes with your own investments.

It's a mystery
Companies will often pay premiums when making acquisitions. The difference between a target firm's fair value and its price tag after acquisition costs ultimately becomes goodwill on the buyer's balance sheet.

An artificial asset, goodwill prevents an imbalance from being created on an acquiring firm's balance sheet that would normally arise after paying more for something than its actual value. Instead of having its liabilities exceed assets or impacting shareholder equity, a company can assign the premium to goodwill and balance its books.

Companies peg goodwill to various sources of expected future cash flows. Those sources can take on a number of forms -- even expected benefits from other types of intangible assets, such as patents and trademarks. If one or more of those sources loses its supposed earning power, however, the goodwill will often be deemed impaired, and the company will take a writedown on its value.

Take warning
So say your company acquires another company, and as part of the acquisition, it receives a number of patents, to which it pegs a portion of newly created goodwill. If those patents become obsolete, then the company typically writes down the goodwill at least to the extent it was pegged to the patents.

Companies are required to test goodwill for impairment at least once a year. Sophisticated accounting practices, however, can make it difficult for investors to figure out which company earnings and revenues are tied to the company's goodwill, and companies have no legal obligation to be fully transparent about such matters.

Perhaps the scariest thing about goodwill is how important a potentially worthless asset can be to the business. A company can borrow on imaginary assets that are susceptible to vanishing at a moment's notice -- and if it has debt covenants tied to its total assets, that can spell disaster.

Red flags
To avoid such problems, analysts sometimes look at the market value of a firm relative to its goodwill. If a company's market cap falls below its book value, that's sometimes a sign that goodwill should be written down.

Of course, some companies have zero goodwill, which implies zero risk of goodwill impairment charges. Among those are ExxonMobil (NYSE:XOM) and Occidental Petroleum. But many companies have reasonably small amounts of goodwill, such as the firms listed below:

The Good

Market Capitalization ($mm)

Goodwill ($mm)

Total Equity ($mm)

Goodwill % Market Cap

Goodwill % Total Equity

Apple
(NASDAQ:AAPL)

85,805

207

22,909

0%

1%

Altria Group
(NYSE:MO)

33,679

77

2,828

0%

3%

Home Depot
(NYSE:HD)

34,469

1,134

17,777

3%

6%

Source for all charts: Capital IQ, a division of Standard and Poor's. Market cap as of March 12.

If a company's goodwill alone exceeds its market capitalization, then that increases the odds of seeing impairments in the near future.

The Bad

Market Capitalization ($mm)

Goodwill ($mm)

Total Equity ($mm)

Goodwill % Market Cap

Goodwill % Total Equity

Ingersoll-Rand (NYSE:IR)

4,442

6,620

10,703

149%

62%

Tyco International

9,097

11,020

14,894

121%

74%

Johnson Controls

5,598

6,392

8,313

114%

77%

And when goodwill completely dwarfs a company's market cap and total equity, which often comes down along with goodwill when the latter becomes impaired, you know something has to give -- and it can end up being just plain ugly.

On the 3:10 to Yuma

Market Capitalization ($mm)

Goodwill ($mm)

Total Equity ($mm)

Goodwill % Market Cap

Goodwill % Total Equity

Gannett
(NYSE:GCI)

496

2,873

1,056

580%

272%

Manitowoc
(NYSE:MTW)

455

1,891

1,300

416%

145%

Newell Rubbermaid

1,444

2,699

1,614

187%

167%

That said, each case must be evaluated independently. After all, there may be valid reasons for carrying so much goodwill on a balance sheet, but you should expect management to explain fully the assumptions it makes when dealing with goodwill. While suspicious numbers can be explained away, a complete lack of transparency is usually an ominous sign.

The impact
When goodwill impairment charges occur, no cash changes hands, so the firm remains unchanged operationally. The impairment does, however, affect its GAAP earnings, and charges have been known to decimate companies' income statements at times.

Having loans tied to asset levels can also create problems. If a company's assets fall below a certain threshold, for instance, some lenders will freeze credit lines or other sources of liquidity, which could mean serious trouble for borrowing firms.

The role of goodwill in your investing
One smart way to deal with goodwill is to do two sets of analysis: one that includes the goodwill, and one that basically treats goodwill as if it weren't there. In other words, subtract it from total assets, and if there's an impairment charge, ignore its effect on the income statement.

All else equal, adjusting a company's balance sheet and income statement for goodwill will increase many ratios such as return on assets and total asset turnover, as it will decrease their denominators. That may give you a better sense of the true situation a company faces.

Repeated goodwill impairment charges can signify that a company has made a poorly timed acquisition, or perhaps the assets it acquired aren't performing as expected. Keep an eye on goodwill levels, and stay alert. At the same time, though, once an otherwise financially sound company's stock price has written off nearly all of its goodwill, bargain-buying opportunities can arise.

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Home Depot and Tyco International are Motley Fool Inside Value selections. Apple is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletters today, free for 30 days.

Fool contributor Chris Jones has neither long nor short positions in any of the companies mentioned in this article. In other news, The Motley Fool's disclosure policy recently withdrew from a presidential cabinet post due to criticisms over its failure to pay income taxes.