Most lenders and credit analysts learn early on to add back depreciation to determine the cash flow available to pay debt and the owners. Shortly thereafter, you learn that amortization is treated in the same way. But the real secret sauce is when you develop the understanding of what difference amortization, versus depreciation, makes in your understanding of the business.
The Definition of Amortization
The short answer: While depreciation is the bookkeeping write-off of tangible items, like buildings and equipment, amortization is the bookkeeping write-off of intangible items, like patents, customer lists, and intellectual property.
Let’s take this a bit further. If you know the definition, do you also know what difference it makes? And what it means if there are intangible assets that are not amortized…or are fully amortized. Let’s walk through an example:
- An insurance company buys the ‘book of business’ of another company, also called the customer list.
- A customer list will get stale if not pursued.
- Customers will go elsewhere if they do not get good service.
- So you might think the customer list is only good for a year or two. If that customer is still with the company, the company has probably earned that continuing business.
- The IRS rule for amortizing a customer list is 15 years. YIKES! So the amount of the asset amortized on the tax return may not represent the degrading of the intangible asset.
More on Amortization (and why you should care)
For more on amortization and how it helps you understand your business borrower, check out our blog post on Amortization in Tax Return Cashflow Analysis. It covers how to use the information on the tax return balance sheet to understand the impact of the intangible asset on the borrower’s business. And why you should care.
More on Tax Return Analysis
Or head over to Lenders Online Training where we turn numbers from tax returns and financial statements into actionable insights so you can say ‘yes’ to more good loans.
