With every business there are expenses, but every expense needs to be paid. That’s where the payback period comes in.
Payback period definition
The payback period describes the amount of time it takes a business to recover the cost of any purchase made. Basically, it is the period required for a company to break even on any outlay. As with any personal purchase you may make, the quicker you can pay it off, the better (like installing solar panels and recouping the cost through savings on energy bills). Therefore, investments with shorter payback periods are preferable.
How to calculate payback period
Essentially, the payback period is the cost of the investment or purchase divided by the company’s annual cash flow. The below payback period formula can be used:
Payback Period = Initial Investment / New Cash Flow Per Period
For example, Company A buys a new asset in the form of equipment worth $600,000 which will generate $100,000 in cash flow each year, so:
$600,000 / $100,000 = 6 Years
Six years may be considered too long by most business owners. As mentioned, the shorter the payback period, the more desirable an investment is, so long term investments may be rejected by your finance team or management who do not want to be tethered to the financial obligation for so long. You can get an idea of the best payback period by comparing all the investments you’re considering, and opt for the shortest one. Generally, a long payback period is determined by your own comfort level – as long as you are paying off one investment, you’ll be less able to invest in newer, promising opportunities.
You can also find payback period calculators online that makes it easy to work out when you will be able to break even.
The payback period disadvantages
Time value of money (TMV)
One of the downfalls of the payback period formula is that it doesn’t take into account the time value of money (TVM). That means that payback period calculations are made on the assumption that the money made today will be worth the same in the future. TMV maintains that money grows in interest, therefore payback period calculations are inaccurate as they do not take inflation rates into consideration. The $600,000 Company A recoups in 6 years will not be worth the same as it was at the time of investment, so in reality it will take longer to recoup the real value.
Other disadvantages include the assumption that the lifespan of a machine surpasses the payback period, but this may not always be the case. Even if the lifespan matches the period discovered while using the payback period formula, it’s not a good investment if the purchase is due to break the moment it’s paid off. In some cases, this may be a risk worth taking, but generally, a better alternative may be available.
The figures used to calculate payback period cash flow are estimates. They could prove to be wrong, and the payback period may become longer than anyone hoped. They also don’t consider further investments the initial investment may need, for example, a machine needing upgrades and repairs.
The payback period formula doesn’t take into account how the investment can impact the rest of the company. For example, Company A may be quite certain that their new machine will increase their cash flow when they calculate payback period numbers, but this doesn’t show how costs will be impacted by other requirements. For example, maybe it will need their current team to undergo training or will increase their energy bills. In this case, the calculated cash flows are no longer accurate. At worst, poorly calculating these extra costs could start to weaken a company’s solvency.
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