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Understanding Amortization Featured

Understanding Amortization person sitting on bench watching sea

If you’re not familiar with accounting or financial statements for a company, just looking at them can be intimidating. Even once you’ve figured out things like gross margin, cost of goods, and cash on hand, there are other line items that will still cause you to scratch your head, like amortization.

What Is Amortization?

Amortization can be a useful tool, but it’s also an abstract concept. While it’s a very tangible line item, it represents spreading a one-time payment over time which may feel counterintuitive to accounting practices that track expenses in real time.

Amortization doesn’t appear on a cash flow statement because the cash is typically laid out up front. Instead, this line item is found on the balance sheet. Amortization is a company’s way of showing the value of a (usually large) one-time payment that represents a benefit for a long period of time.

Understanding The Abstract

For instance, if your supplier has a great idea for a new product of yours, you may want to buy the rights to that intellectual property from them. There’s not a physical ‘thing’ that trades hands, but the IP is still worth what you and the seller agree it is worth. Continuing with our example, if you estimate that the IP is going to be valuable to your company for 5 years, that is how long you would amortize the payment to the seller. So, if you paid $50,000 for the IP, you would have $10,000 amortized on each of your next 5 years’ balance sheets.

So why doesn’t that $50,000 you paid appear in cash flow? Shouldn’t that appear as a $50,000 expense on all of your financial statements? The short answer is, ‘no’. It should appear on your cash flow for the period that you spent the cash. You no longer have the $50K cash, so that needs to be accurately represented because cash is king, and if you don’t keep good track of cash on hand, your balance sheets can look flush even as you’re struggling to cut payroll.

Putting It To Good Use

As long as you keep your eye on your cash flow, Amortization is a critical tool for measuring the health of your company. Amortizing these 1-time spends across the useful life of the asset helps level out how your business is doing on your balance and income statements.

Amortizing the $50,000 spent on the IP in our example above across all of your monthly income statements helps show how much this new product is adding to the top line, and then how much is being depleted from your bottom line by the cost of the IP, month over month or year over year.

This also gives your management team a powerful tool to know when to pull the lever on buying new trademarks, license agreements, or intellectual property, or when to hold fast so that you don’t over-leverage yourself with every ‘great’ idea that comes your way. If you are already over-budget on amortization because your R&D team got overzealous in buying up IP, you know it’s time to pump the brakes until some of that spending shows in your finances as payments completed, or fully amortized.

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