The payback period is the amount of time it takes a business to recoup invested funds or reach a break-even point. It is particularly useful when deciding whether to invest funds in a new project.
The payback period is the time it will take for your business to recoup invested funds. For instance, if your business was considering upgrading assembly line equipment, you would calculate the payback period to determine how long it would take to recoup the funds used to purchase the equipment.
We’ll explain what the payback period is and provide you with the formula for calculating it.
The payback period formula is easy to calculate. Image source: Author
Overview: What is the payback period?
Any time a business purchases an expensive asset, it’s an investment. Capital equipment is purchased to increase cash flow by saving money or earning money from the asset purchased. For example, let’s say you’re currently leasing space in a 25-year-old building for $10,000 a month, but you can purchase a newer building for $400,000, with payments of $4,000 a month.
While you know up front you’ll save a lot of money by purchasing a building, you’ll also want to know how long it will take to recoup your initial investment. That’s what the payback period calculation shows, adding up your yearly savings until the $400,000 investment has been recouped.
Similar to a break-even analysis, the payback period is an important metric, particularly for small business owners who may not have the cash flow available to tie funds up for several years. Using the payback method before purchasing an expensive asset gives business owners the information they need to make the right decision for their business.
Calculating the payback period is also useful in financial forecasting, where you can use the net cash flow formula to determine how quickly you can recoup your initial investment. Whether you’re using accounting software in your business or are using a manual accounting system, you can easily calculate your payback period.
What is the payback period formula?
Still undecided about whether to purchase a new building, you decide to calculate your payback period. To calculate it, you would divide the investment by the cash flow the investment would create. Here, the monthly savings or cash flow amount would be $6,000 per month or $72,000 per year. To calculate your payback period, you’ll divide the cost of the asset, $400,000 by the yearly savings:
$400,000 ÷ $72,000 = 5.5 years
This means you could recoup your investment in 5.5 years. It’s important to note that not all investments will create the same amount of increased cash flow each year. For instance, if an asset is purchased mid-year, during the first year, your cash flow would be half of what it would be in subsequent years. When that’s the case, each year would need to be considered separately.
For example, if the building was purchased mid-year, the first year’s cash flow would be $36,000, while subsequent years would be $72,000.
- Year 1: $36,000
- Year 2: $72,000
- Year 3: $72,000
- Year 4: $72,000
- Year 5: $72,000
- Year 6: $72,000
- Year 7: $ 4,000
This means the amount of time it would take to recoup your initial investment would be more than six years.
A payback period example
Cathy currently owns a small manufacturing business that produces 5,000 cashmere scarfs each year. However, if Cathy purchases a more efficient machine, she’ll be able to produce 10,000 scarfs each year. Using the new machine is expected to produce an additional $150,000 in cash flow each year that it’s in use.
The new machine will cost $350,000 to purchase, and Cathy doesn’t want her funds tied up any longer than three years. Let’s calculate the payback period to see how long it will take Cathy to recoup her investment:
$350,000 ÷ $150,000 = 2.3 years
The result means that Cathy can recoup her initial investment in a little over two years. That’s less than her three-year requirement, so Cathy goes ahead and purchases the machine at the beginning of the year.
While the payback period calculation is a helpful tool for decision making, there are a lot of things it doesn’t address, such as capital expenditures and overall operating cash flow, which should also be included in the decision making process.
A $150,000 project investment with annual cash flow of $32,000 can be recouped in 4.69 years. Image source: Author
FAQs
The shorter the time frame to recoup an investment, the better. The longer the payback period, the longer funds are tied up, which can be detrimental to smaller businesses that operate on a tighter budget.
Calculating the payback period can help assess the risk of investing in an expensive asset. While it may be tempting to upgrade your manufacturing machinery or purchase a new building, both of these purchases carry a great deal of risk.
Calculating the payback period can help mitigate some of those risks, providing you with a clear picture of just how long it will take to recoup the funds you invested. It can also help you steer clear of a potentially bad investment, or one that will take too many years to recoup.
No. The payback period calculation is simple:
Investment ÷ Annual Net Cash Flow From Asset
It can get a bit tricky when annual net cash flow is expected to vary from year to year. If that’s the case, you’ll have to calculate each year’s cash flow totals to determine the payback period.
When calculating the payback period on a potential asset or other investment, it’s helpful to know the time value of money. This is important if your payback period is more than five years, as money paid back in the future will be worth less than it was at the time of the initial investment.
How the payback period calculation can help your business
Are you still undecided about investing in new machinery for your manufacturing business? Perhaps you’re torn between two investments and want to know which one can be recouped faster? Maybe you’d like to purchase a new building, but you’re unsure if the savings will be worth the investment. Calculating the payback period for the potential investment is essential.
Calculating your payback period can be helpful in the decision-making process. It may be the deciding factor in whether you should go ahead with the purchase of that big-ticket asset, or hold off until your cash flow is better. Small businesses in particular can benefit from payback analysis simply by calculating the payback period of any investment they’re considering.
Before you invest thousands in any asset, be sure you calculate your payback period. You won’t be sorry.
