How Understanding “Amortization” Can Help Business Owners Make Informed Financial Decisions

Understanding “Amortization” can positively influence how business owners and entrepreneurs strategically plan their cash flow and also help them make more informed financial decisions.

But to make use of this, you first need to properly understand what exactly it is and its’ types.  

What do you mean by “Amortization”?

“Amortization” is a term that is frequently used in the accounting and finance sectors of businesses. It is an exercise that describes the gradual reduction of initial cost of a non-physical asset over the time of its use. Non Physical assets are also called intangible assets like trademarks and patents.

It also implies to the process of repayment of a loan or debt through scheduled payment.

What are different ways to use this technique?

There are two basic types of using this technique.

Amortization of an Asset:

This type refers to the organized distribution of the value of an intangible asset over the time of its use.

Example:

Lets’ say a company buys a patent that costs $5000 and it plans to use that patent for next 5 years. In this case, the company will most probably “amortize” this cost ($5000) by writing off $1000 of its annual profits for the next five years.

Amortization of a Loan:

This type involves paying off a loan over a specified period of time in regular instalments, where instalment will cover both principle amount and interest over it.

Example:

If a company takes a loan of $100,000 with a 10 year term of payment at a fixed interest rate, then the company will make a monthly instalment plan to make sure that the entire loan is paid off by the end of 10 year time period.

Why is it important for Entrepreneurs and Business Owners to know and understand Amortization?

To Periodically Understand Financial Situation of a Business:

 A proper knowledge of how to use this accounting process can help business owners to properly identify and record all expenses for their business and understand financial condition of their business from time to time.  

To Understand Tax Implications:

When business owners learn to properly amortize expenses, they can systematically spread cost of their assets over multiple years and significantly reduce annual taxable income. This can help a business to better understand tax implications.

To be Able to Manage Debt of their Business:

Those business owners who are dealing with debts or loans, a comprehensive understanding of amortization is crucial to know how much of loan payments goes toward principle amount and how much goes towards interest. This helps in planning budgets ahead and making informed decision keeping in mind the instalment payments.

How Understanding “Amortization” can help Business Owners Make Informed Financial Decisions

With the help of Amortization, a prior estimation of cash flow can be expected to help business owners to ensure they have enough liquidity to cover both operating costs and debt commitments, which will automatically translate into better economic condition of a company.