5 Things You Should Know About the Payback Period
For corporate finance, understanding the payback period is an important part of any accounting model. In summary, the payback period is the amount of time it takes to pay back a particular investment and is typically measured in a number of years.
For example, say a housing contractor invests $20,000 in expanding their business and it takes them three years to earn back that $20,000. The payback period would be three years. Business owners will find that the type of investments tracked with a payback period varies depending on their industry and the needs of their business; some organizations might need to track investments in equipment, space, or a degree.
The payback period can be used to help businesses and lenders determine if something is a good investment. Something with a longer payback period won't be considered as favorable as an investment with a short payback period.
For businesses interested in simplifying their accounting practices. Skynova offers accounting software that can help them track their investments and payments. This can assist small businesses like yours in determining the best investments to keep moving forward.
What Is the Payback Period?
The payback period method is a capital budgeting strategy that calculates the period of time it will take a business to recuperate its money after an investment. It looks at cash inflows and uses that to see when they've made the initial investment back.
However, this calculation only looks at how long it takes the business to make back its original investment. It doesn't take into account the money or profit that the business can generate after the initial funds have been recouped (called the overall profitability of an investment).
This calculation can help organizations better evaluate the best investments for their businesses. Generally, those with shorter payback periods are better than those with long payback periods.
For small business owners, the biggest benefit of the payback period calculation is its simplicity. It's a quick calculation that can be run for various projects with ease. This makes it simple to evaluate different investment opportunities and options, helping business owners make the best decisions for their companies.
Benefits and Drawbacks of the Payback Method
The payback method provides a simple, straightforward calculation for business owners as they evaluate potential investments. Its biggest attraction for accountants and small business owners comes from the ease of use.
However, there are a few shortcomings with the method. The formula doesn't take into account the time value of money (TVM), which refers to the value of the money itself. Generally, because of how the economy works, money today is worth more than the same amount will be worth in the future. In other words, money that someone has right now can begin earning interest. Money is always worth more the sooner it can be secured because it will have more time to earn interest. Therefore, businesses should also examine the lost opportunity cost and the interest rate on investments when it comes to earning interest on funds.
Businesses have a few other equations they can use to calculate the potential benefits of a particular investment, including the net present value (NPV) and the internal rate of return (IRR), which both account for the time value of money in their calculations. However, since these formulas have more points to take into account, the formula for calculating them is also significantly more complicated.
Many business owners find that the payback period calculator works best when used for a quick understanding of investments or as a single tool in a full toolbox of evaluations for determining a worthy investment.
As mentioned, the payback period doesn't take into account what happens after the business earns back the money from the loan. Therefore, it disregards the potential profits the business could gain moving forward. This paints a slanted picture of the value of the investment.
Breaking Down the Formula for the Payback Period
The payback period formula takes into account three points of data. Collecting this information will allow businesses to evaluate potential investments without having too much prior accounting insight. Even those who have not studied bookkeeping can use this calculation to evaluate their investment decisions.
The payback period formula is:
Here are the three data points you'll need to collect to execute this formula.
The initial cost or investment is the amount of money needed to start your investment or other project. This is the amount of money that the business had to pay when getting started on their project. The initial investment could be in the form of cash or credit.
Opening Cumulative Cash Flow
Your company will have cash flow sheets that track cash inflows and cash outflows. The cumulative net cash flow looks at what you get when you combine all positive cash flows and negative cash flows. If you earn more money than you spend, you have a positive number. If you spent more money than you made, you'll have a negative number for your answer.
You'll look at the cumulative cash flow to determine between which two years the investment will recuperate. If you had a loan of $10,000 and had a cumulative cash flow of $7,000 by year three and $12,000 by year four, for instance, you know the payback period was some time between years three and four.
For the top line of the formula, the opening cumulative cash flow would be the cash flow in year three: $7,000.
Closing Cumulative Cash Flow
With the closing cumulative cash flow, you follow the same steps you did to find the opening cumulative cash flow. This time, however, you take the cumulative cash flow number that comes after you have recuperated the cost. In the example above, your closing cumulative cash flow will be $12,000. Plug this number into the bottom of the equation.
Now, it's time to run the calculation. In the example we used, we would have:
This would give us 0.6. Since we know the payback took place at some point between years three and four, we can determine that the payback period is 3.6 years.
Payback Period Example
Sometimes, the best way for those new to accounting to get used to the different equations associated with annual cash flow and capital budgeting is to provide examples.
Consider a home improvement business that wants to expand. After doing the market research, they decide they want to spend $12,000 investing in the company right now. After two years, they have made back $8,000 from the ability to cover more areas and improve their services. Their financial statements show they have made $14,000 in cumulative cash flow the following year. To evaluate their decision-making, they can calculate their payback period.
Therefore, the length of time it took this company to recuperate costs on the investment was 2.67 years.
Accounting Software Can Help You Determine Payback Periods
Businesses interested in improving their bookkeeping methods should consider how Skynova makes it easy to calculate important equations, track metrics, and keep their account running smoothly. Skynova offers a variety of products, including templates and accounting software, that make running a business simple and straightforward.
Notice to the Reader
The content within this article is meant to be used as general guidelines and may not apply to your specific situation. Always consult with a professional accountant for specific advice regarding different bookkeeping practices.