Before applying for capital to give your small business a boost in cash flow, make sure you’re familiar with the lending terminology.
If you choose to apply for your SBA 7(a) loan through the SmartBiz Loans marketplace, you’ll come across the term “amortization.” Here’s what can help you understand the basics.
What is Amortization?
In the context of lending, an “amortizing” loan is one that is spread throughout its term with regular fixed payments. The balance goes down with every installment until it is completely paid off, or amortized. SBA loans through SmartBiz® bank partners are fully amortizing, which means that your monthly payments will go toward paying down the balance until it’s reduced to zero. Learn more about the SBA loans and other financial products available through SmartBiz here.
Amortization is also involved when it comes to accounting for your small business. In that case, it has a similar definition: spreading the cost of a resource over a certain duration. But rather than applying to a loan, the term relates to the cost of your business’s assets.
Are All Loans Amortized?
The vast majority of, but not all, small business loans are amortized. Any loan for which you make the same loan payments every month until your term ends is amortized. SBA loans are thus classic examples of amortized loans, as their structure requires equal payments every month (and your interest rate should remain unchanged too).
Loans that aren’t amortized include revolving lines of credit (such as credit cards) and balloon loans (which include some short-term business loans). Credit cards are a type of non-amortized debt because you can pay them off as soon or as late as you want. Balloon loans initially require equal monthly payments before pivoting to one large final payment, and this structure disqualifies these loans from counting as amortized.
How Amortization Works
According to Investopedia, amortization is defined as “an accounting technique used to incrementally lower the cost value of a finite life or intangible asset through scheduled charges to income.”
Amortization is calculated by breaking down the cost of an intangible asset like a license, patent, or trademark into a certain number of payments over its useful life, which refers to the expected time in which the asset will serve its purpose for the company.
How Do You Calculate Amortization?
When it comes to loans, amortization isn’t a quantity – it’s a concept. That said, you can calculate a loan’s amortization schedule by taking the following steps:
- Multiply your total loan amount by your interest rate.
- Divide the result by 12. The dividend is your monthly interest payment.
- Subtract this interest from your monthly payment. The remainder is your principal payment.
- Repeat this process next month, but instead of using your total loan amount in step one, use your remaining loan balance.
A formula summarizing this all would be:
Principal payment = monthly payment - (total loan amount * interest rate)/12
An example should help clarify. Let’s say your SBA loan amount is $100,000 with an interest rate of 8%. This means that your monthly interest payment is $100,000 * 0.8 / 12 = $666.67. If your monthly payment is $1,666.67, then your principal payment is $1,000.
As such, next month, your balance is $100,000 - $1,000 = $99,000. Your monthly interest payment is now $660, meaning your principal payment is $1,666.67 - $660 = $1,007.67.
Amortization for Assets
Beyond loans, amortization also applies to intangible assets such as trademarks and patents, copyrights, franchise agreements, and organizational costs. Additionally, calculating the amortization of intangibles is far simpler than with loans.
Dividing the intangible asset’s price by its useful life leaves you with the regular amortization. For example, if you spent $45,000 on a patent and expect it to last for 15 years, its annual amortization would be $3000. In other words, the asset’s value would decrease by $3000 every year.
How Does Amortization Affect a Balance Sheet?
Amortization plays into balance sheets since it affects the cost of your assets. As described above, a 15-year patent worth $45,000 isn’t a $45,000 asset five years after you get the patent. Instead, it’s worth $45,000 - 5 * $3,000 = $45,000 - $15,000 = $30,000. You would thus add $15,000 to your amortization amount on your balance sheet and $30,000 to your asset amount.
Notably, the above only applies to the cost of an intangible asset. For tangible assets, you would quantify any value drops as deprecation. This is among the key differences separating amortization and depreciation.
Amortization vs. Depreciation: How They Differ
The main distinction between amortization and depreciation is the assets that define them. Other differences exist, and all differences are outlined below.
- Tangible vs intangible objects. While amortization is calculated specifically for intangible assets, which are not physical objects, depreciation is linked to tangible or fixed assets like equipment, machinery, and cars. This leads to another difference:
- Resale value. Assets that have been amortized usually don’t have an inherent resale value, while assets that have been depreciated often do. When calculating depreciation, this amount, called the salvage value, is taken into account by subtracting from the total cost of the asset before dividing by the useful life.
- Asset versus expense. You can also think of amortization as the cost of a key asset and depreciation as a way of expensing a physical asset during its lifetime. Put another way, amortization shows how a sales-generating asset’s value declines the more sales it generates, and depreciation shows how the items underlying your production process lose value.
If you’re still confused, that’s understandable. Learning more about depreciation as you learn about amortization can help to clarify.
What Is Depreciation?
Depreciation describes the expensing of a fixed asset while it retains its usefulness. In the context of your business, depreciable items include machinery, office equipment and furniture, machinery, land and vehicles.
You can calculate depreciation by subtracting a physical asset’s current resale value from the amount that you originally spent to obtain it. For example, if you purchased one of your company’s forklifts for $25,000 but expect that you’ll only be able to sell it for $12,000, its depreciation is $13,000.
The annual amount of this depreciation is tax-deductible. If this $13,000 depreciation takes place over three years, then the forklift in question depreciates $13,000/3 = $4,333 per year. As such, you can claim a $4,333 depreciation deduction during a given tax year.
Certain physical assets are depreciated unevenly over a period of time. Company vehicles are a perfect example, as typically, a larger portion of a car’s value is depreciated in its early years than its later years. Following this logic, cars can make a larger short-term difference in lowering your company’s taxable income than your other fixed assets.
Where Do Depreciation and Amortization Appear on a Balance Sheet?
You should record depreciation and amortization on your balance sheet in the appropriate asset category. In your assets section, your depreciation should be the final line item of your physical assets section underneath your buildings, equipment, and other tangible assets. Note that its value should be negative, whereas each asset’s value will be positive.
Likewise, your amortization is expensed as a negative value under your intangible assets on your balance sheet. Often, balance sheets do not distinguish intangible assets from one another, so instead of listing out your intangibles one by one, group them, then record your amortization.
Note that neither amortization nor depreciation is recorded as a liability. Instead, since they are natural consequences of assets existing and aging, you’ll record them in the appropriate assets section.
Why Amortization and Depreciation Matter
Amortization and depreciation often appear on income statements, also known as Profit and Loss (P+L) statements. This kind of financial document is one of the most commonly requested by lenders, because it helps them get a picture of your business’s performance over a period of several years.
Both amortization and depreciation also directly affect your business’s taxable income. Each year, the total depreciation and amortization are subtracted from your reported income, reducing the amount of taxes your company owes through deductions.
