Amortization

What does amortization mean?

Amortization (in German Amortisation) refers to the return of the capital invested in an investment and, following the English term, the scheduled write-down of intangible assets. An investment has paid for itself as soon as the additional receipts or savings it brings have recovered its acquisition cost; the time until then is called the payback period (in German Amortisationsdauer). In accounting, amortization stands for the write-down of software, licences or an acquired customer base.

The word is also used for the scheduled repayment of a loan over its term, which a repayment schedule sets out. What all meanings have in common is the idea that an amount is paid back or spread over time. Companies encounter the term in investment decisions, in bank discussions, in the financial model and in purchase price negotiations, for example in EBITDA, whose A stands for the write-down of intangible assets. Because the term is ambiguous, documents and negotiations should make clear which meaning is intended.

Calculating the amortization of an investment

Static payback calculation

The static calculation compares the acquisition outlay with the average annual cash inflow:

Formula: payback period in years = acquisition outlay ÷ average annual cash inflow

The cash inflow is the additional cash surplus that the investment generates: additional receipts or saved payments, reduced by the ongoing payments for operation and maintenance. Depreciation and amortization are not a cash outflow and do not belong in the calculation. If the cash inflows fluctuate from year to year, they are accumulated until their sum reaches the acquisition outlay.

Dynamic payback calculation

The dynamic calculation takes the time value of money into account. Each future cash inflow is discounted to the date of the investment at a calculation interest rate (discount rate). The investment has paid for itself as soon as the sum of the discounted cash inflows reaches the acquisition outlay. The dynamic payback period is therefore always longer than the static one.

Informative value and limits

The payback period is a measure of risk, not of profitability. It shows how long the capital invested is tied up and exposed to the risk of loss. It disregards what happens after the payback point. Two investments with the same payback period can differ greatly in profitability if one continues to deliver surpluses for years afterwards and the other becomes worthless. For investment decisions it is therefore combined with the net present value (the sum of all discounted payments of the investment) or the internal rate of return (the return that the investment generates).

Amortization as the write-down of intangible assets

The German Commercial Code (Handelsgesetzbuch, HGB) does not use the term amortization. It speaks uniformly of write-downs (Abschreibungen), regardless of whether property, plant and equipment or intangible assets are affected. English, by contrast, distinguishes depreciation for property, plant and equipment such as machinery and buildings from amortization for intangible assets such as software, licences, customer relationships or goodwill. Through English-language financial statements, valuations and loan agreements, amortization in this sense is also common in German usage. The related metric EBITA (earnings before interest, taxes and amortization) therefore deducts only the depreciation of property, plant and equipment. The write-downs of intangible assets, above all of acquired goodwill, are left out.

This kind of amortization carries particular weight after a company acquisition. The acquirer allocates the purchase price to the assets acquired and the liabilities assumed (purchase price allocation). In doing so, intangible assets such as technology, customer relationships and brands are also recognised that were not on the balance sheet of the company sold. What remains of the purchase price is goodwill. The scheduled write-down of these assets reduces EBIT in the following years, but not EBITDA, and it costs no liquidity because the purchase price has already paid for them.

The sets of rules differ on goodwill. Under the HGB, goodwill acquired for consideration is written down on a scheduled basis over its useful life; if this cannot be estimated reliably, over ten years. For tax purposes, goodwill acquired in an asset deal (purchase of the individual assets rather than the shares) is written down over 15 years. Under IFRS, it is not written down on a scheduled basis but tested annually for impairment.

Amortization of a loan: the repayment schedule

In financing, amortization refers to the scheduled paying down of a loan as set out in the repayment schedule. Common are instalment loans with constant repayment, annuity loans with a constant total instalment of interest and repayment, and bullet loans, which are repaid only at the end in one sum. Promotional loans often provide for initial years free of repayment. Venture debt often begins with a phase in which only interest is paid and then moves to monthly repayment. In leasing, a distinction is made between full-payout leases, in which the instalments of the basic lease term cover all of the lessor's costs, and partial-payout leases, in which a residual value remains open.

For the company, the distinction between interest and repayment is essential: interest is an expense and reduces earnings, while repayment only reduces the liability and burdens liquidity alone. The sum of the two is the debt service, against which banks measure debt service capacity.

Significance in financing and company acquisitions

When debt capital is raised, banks examine whether the repayment schedule fits the expected cash flow and the useful life of the item financed. A machine used for ten years can be repaid over seven years, whereas a software licence with a useful life of three years cannot. In acquisition financing, for example in a management buyout, the repayment profile determines how much debt the acquired company can service from its free cash flow. A vendor loan is usually repaid only after the bank loan.

In growth companies, the logic of amortization is transferred to customer acquisition. The CAC payback period measures after how many months a customer's contribution margin has recovered the cost of acquiring them. Investors use it as an early indicator of how capital-intensive growth is.

Worked example: calculating amortization for an investment and an acquisition

A company invests EUR 240,000 in software to automate its invoice verification. It saves EUR 90,000 in personnel costs per year and causes EUR 18,000 in ongoing licence and maintenance costs. The calculation interest rate is 8%.

• Annual cash inflow: 90,000 minus 18,000 = EUR 72,000
• Static payback period: 240,000 / 72,000 = 3.33 years, that is, around three years and four months
• Discounted cash inflows of years 1 and 2: 72,000 / 1.08 = EUR 66,667 and 72,000 / 1.1664 = EUR 61,728
• Discounted cash inflows of years 3 and 4: 72,000 / 1.2597 = EUR 57,156 and 72,000 / 1.3605 = EUR 52,922
• Sum after four years: 66,667 + 61,728 + 57,156 + 52,922 = EUR 238,473, that is, still EUR 1,527 below the acquisition outlay
• Dynamic payback period: just over four years, because a further EUR 49,002 is added in the fifth year

The investment paid for itself statically after a little over three years and, taking interest into account, only after a little over four years. If the software is expected to be used for five years, only a narrow buffer remains; with three years of use it would not pay for itself.

The second meaning is shown by an acquisition. A software company acquires the business of a smaller competitor in an asset deal for EUR 2,000,000. In the purchase price allocation, the customer relationships taken over are recognised at EUR 900,000 and the software taken over at EUR 600,000. After the acquisition, the company's EBITDA is EUR 1,500,000 and the depreciation of property, plant and equipment is EUR 100,000.

• Goodwill: 2,000,000 minus 900,000 minus 600,000 = EUR 500,000
• Amortization of the customer relationships over six years: 900,000 / 6 = EUR 150,000 per year
• Amortization of the software over four years: 600,000 / 4 = EUR 150,000 per year
• Amortization of goodwill under the HGB over ten years, because its useful life cannot be estimated reliably: 500,000 / 10 = EUR 50,000 per year
• Total amortization: 150,000 + 150,000 + 50,000 = EUR 350,000 per year
• EBITA: 1,500,000 minus 100,000 = EUR 1,400,000
• EBIT: 1,400,000 minus 350,000 = EUR 1,050,000
• Tax write-down of goodwill over 15 years: 500,000 / 15 = around EUR 33,333 per year

Amortization reduces EBIT by a quarter of EBITA without any liquidity flowing out in the following years; the purchase price has already paid for it. After acquisitions, buyers and banks therefore often look at EBITDA or EBITA to see the ongoing business undistorted.

Distinction: amortization, depreciation, repayment and break-even

• Depreciation and write-downs: the umbrella term under commercial law for spreading acquisition costs over the useful life. Amortization in the accounting sense is the part that relates to intangible assets; the payback period of an investment, by contrast, measures when the money invested has flowed back.
• Repayment: the individual payment on a loan. Amortization refers to the entire course of paying down, which the repayment schedule describes.
• Break-even: the point at which revenue covers the costs of a period. It describes an earnings threshold, not a return of capital.

Common mistakes

• Calculating with profit instead of cash surplus. Anyone who uses profit after depreciation artificially lengthens the payback period.
• Leaving out follow-up costs. Maintenance, licences, training and spare parts reduce the cash inflow and belong in the calculation.
• Looking only at the payback period. It says nothing about returns after the payback point and favours short-term projects.
• Confusing the meanings. If a loan agreement or a valuation says “amortization”, it must be clarified whether write-downs or repayments are meant. The former reduce earnings, the latter only liquidity.
• Overlooking repayment-free phases. When the interest-only phase of a loan ends, debt service jumps; a plan that does not show this overestimates the runway.

Frequently asked questions

What is the difference between amortization and depreciation?

That depends on the meaning. Depreciation is a bookkeeping entry that spreads acquisition costs over the useful life. The amortization of an investment, by contrast, is a decision metric that measures the return of the capital invested. In the accounting sense, amortization is finally a part of write-downs, namely the part on intangible assets.

What payback period is acceptable?

That depends on useful life and risk. A payback in five years is unremarkable for an asset with a useful life of ten years, but not viable for software that is replaced after three years. Many companies set a maximum period for investment decisions.

Why does the A in EBITDA stand for amortization?

Because English accounting calls write-downs of intangible assets amortization. EBITDA is therefore earnings before interest, taxes and all write-downs.

Is an annuity loan more expensive than an instalment loan?

With the same interest rate and term, somewhat more interest accrues in total, because the outstanding balance falls more slowly at first. For EUR 500,000, a term of five years and 6% interest, the instalment loan costs EUR 90,000 in interest and the annuity loan around EUR 93,500. In return, the annual instalment of the annuity loan stays the same at around EUR 118,700, whereas that of the instalment loan falls from EUR 130,000 to EUR 106,000.

Is internally developed software amortized?

Yes, if the company has capitalised the development costs under the HGB option. They are then written down over the expected useful life. If the costs are expensed immediately, there is nothing to amortize; for tax purposes this is the only route anyway.

The Roemer Capital view

For growth companies, the most important payback calculation in Roemer Capital's view is that of customer acquisition. A CAC payback of under 12 months is seen as a sign that additional capital in sales and marketing flows back quickly. If it is well above that, Roemer Capital explains to investors why this is so and how it is meant to develop.

Roemer Capital shows existing loans in the financial model with their full repayment schedule, including the end of repayment-free phases. This makes visible how much runway actually remains after debt service and when follow-on financing becomes necessary.