Ideally, businesses would pursue all projects and opportunities that hold potential profit and enhance their shareholder’s value. However, there’s a limit to the amount of capital and money available for companies to invest in new projects.
That’s why business owners and managers need to use capital budgeting techniques to determine which projects will deliver the best returns, and yield the most profitable outcome.
One of the most important capital budgeting techniques businesses can practice is known as the payback period method or payback analysis.
In this guide, we’ll be covering what the payback period is, what are the pros and cons of the method, and how you can calculate it, with concrete business examples.
Read along to learn more about:
- What Is a Payback Period?
- Advantages and Disadvantages of the Payback Period
- Payback Period Formula
- Payback Period Example
- Automate Your Expenses with Accounting Software
- Payback Period FAQ
What Is a Payback Period?
A payback period refers to the time it takes to earn back the cost of an investment. More specifically, it’s the length of time it takes a project to reach a break-even point. The breakeven point is the level at which the costs of production equal the revenue for a product or service.
Generally speaking, an investment can either have a short or a long payback period. The shorter a payback period is, the more likely it is that the cost will be repaid or returned quickly, and hence, the more desirable the investment becomes. The opposite stands for investments with longer payback periods - they’re less useful and less likely to be undertaken.
Advantages and Disadvantages of the Payback Period
One of the biggest advantages of the payback period method is its simplicity. The method is extremely simple to understand, as it only requires one straightforward calculation. Hence, it’s an easy way to compare several projects and then to choose the project that has the shortest payback time.
With this being said, there are a few drawbacks to the analysis.
Firstly, it fails to consider the time value of money, as cash flow obtained in the initial years of a project is valued more highly than cash flow received later in the project's process. For instance, two projects may have the same payback period, but one generates more cash flow in the early years and the other generates more profitability in the later years. In this case, the payback method does not provide a strong indication as to which project to choose.
Another disadvantage of the method is that it disregards cash flows received after the payback period: it might happen that the largest cash flows for some projects may not take place until after the payback period has ended. These projects may ultimately provide higher profits and may even be more profitable in the long run than projects with shorter payback periods.
Now you might be wondering: should I use the payback period analysis? If so, what’s the most appropriate case?
Considering that the payback period is simple and takes a few seconds to calculate, it can be suitable for projects of small investments. The method is also beneficial if you want to measure the cash liquidity of a project, and need to know how quickly you can get your hands on your cash.
However, the payback period ignores several important factors, like the time value of money and other risks associated with financing and investment. So, it’s recommended that you use this method in combination with other capital budgeting techniques, for a well-thought and sound investment decision.
Payback Period Formula
As the payback period is usually expressed in years, its length is calculated by dividing the amount of investment, by the annual net cash inflow. So, the formula for the payback period goes as follows:
Payback Period = Initial Investment / Cash Flow per Year
Payback Period Example
Assume Company XYZ invests $3 million in a project, which is expected to save them $400,000 each year. The payback period for this investment is 7 and a half years - which we calculate by dividing $3 million with $400,000, using the formula shown below:
Payback Period = $3,000,000 / $400,000 = 7,5 years
Now, consider a second project that costs $400,000 with no associated cash savings, that will make the company $200,000 each year for the next 20 years. In the end, the company will have earned $4 million from this investment.
It’s clear that the second investment will make the company $1 million more in the long run, but how much time will it take them to pay it back?
Using the payback period, we divide $400,000 by $200,000 to find that they can pay back the investment in just two years. So, not only will the second project yield better profits, but according to the payback analysis, it will also take less time for the company to pay it back.
Automate Your Expenses with Accounting Software
By adopting cloud accounting software like Deskera, you can track your costs, send purchase orders, overview your bills, generate expense reports, and much more - through a single, user-friendly platform.
So, instead of manually journalizing transactions and calculating your investment returns in physical books and spreadsheets, all of your data will be digitally stored in the cloud, easily manageable, and accessible from anywhere.
Payback Period FAQ
#1: What is a Good Payback Period?
The payback period with the shortest payback time is generally regarded as the best one. This is an especially good rule to follow when you must choose between one or more projects or investments. The reason for this is because the longer cash is tied up, the less chance there is for you to invest elsewhere, and grow as a business.
#2: What’s the Difference Between the Payback Period and the Breakeven Point?
The breakeven point is a specific price or value that an investment or project must reach so that the initial cost of that investment or project is completely returned. Whereas the payback period refers to the time it takes to reach the breakeven point.
#3: What’s the Difference Between the Payback Period and ROI?
Return on Investment (ROI) is the annual return you receive on investment, and it measures the efficiency of the investment, compared to its cost. A high ROI means the investment's gains are greater than its cost. A payback period, on the other hand, is the time it takes to recover the cost of an investment.
So, if an investment of $200 has an annual return of $100, the ROI will be 50%, whereas the payback period will be 2 years ($200/$100).
And that’s a wrap!
For a quick recap, let’s go through the main points we’ve covered:
- The payback period method is a capital budgeting technique that determines how profitable an investment is, by calculating how much it takes to earn back its cost.
- The payback period is easy and straightforward to calculate, however, it fails to consider the time value of money and disregards cash flow received after the payback period. That’s why the method is best used for smaller investments and projects.
- The length of the payback period is calculated by dividing the amount of investment, by the annual net cash inflow.
- Use accounting software like Deskera to automate your cost calculations, and keep tabs on all of your expenses, in a single dashboard.