INTM515050 - Thin capitalisation: practical guidance: measuring earnings: the effect of amortisation

Amortisation of goodwill or other intangible assets involves writing off the asset over its useful life, of the value of assets over and above what they cost. As such, it does not usually reflect a cash expense in the year in which amortisation begins, and it is often contended that it should be added back routinely in the calculation of interest cover. This contrasts with the question of adding back depreciation, which as explained at INTM515040 is likely to result in future capital expenditure to replace assets.

In practical terms, any ongoing extra costs arising from the acquisition of a business will register elsewhere: in the profit and loss account forecasts, as estimates for one-off or short-term costs such as redundancies or aligning previously separate businesses, and in additional capital expenditure. Those issues can be looked at individually while examining the plans and forecasts for the business. It is arguable (though see the bullet points at the bottom of INTM515040) that in a steady state business the depreciation charge has some relation to future levels of capital expenditure, so that to leave the deduction in the profit and loss account makes some sense. The amortisation charge is unlikely to perform a similar function.

However, it may be worth considering whether adding back amortisation will produce a future impact on cash flow not otherwise accounted for. Amortisation may relate to the acquisition of intellectual property rights - patents, copyrights, etc - written off over their useful economic life, and that may point to future costs associated with their preservation and enhancement.

In cases where EBITDA is used, it is normal to look for a higher interest cover ratio than when a ratio based on EBIT is used, since EBITDA makes no provision for capital expenditure, and earnings will have to cover capital costs as well as interest, dividends, loan repayments, etc.

Note: the term ‘amortisation’ also refers to the reduction of debt over time by means of regular payments of interest and principal, so a loan amortised over five years will be gradually paid off over that period.