The payback period is a financial capital budgeting method that estimates the amount of time needed for an investment to generate cash flow and replace the cost of the investment.
So, it’s the amount of time it takes for an investment to get enough cash in order to pay for itself. It’s relevant to management, as it can help analyze the risks of different investments.
Let’s take a look at the definition of this metric, how you can utilize it, and how you can calculate it for your investments.
Payback Period – Definition
As expected, the investment is riskier if it takes too long for an investment to repay its initial price. Usually, if the payback period is longer, then the investment is less lucrative.
If a period is shorter, it means that the management can get their cash back sooner and can easily invest it into something else. If a period is longer, the cash remains tied up in investments with no ability to reinvest the earnings somewhere else.
So, management can use this calculation to decide what investments or projects are worth pursuing, and if they can afford to wait for a return on the expended funds.
Analyzing Payback Period
As mentioned above, payback period calculation is used by management to find out how quickly they can get the firm’s money back from an investment. It’s better to happen sooner than later.
Most of the time, longer payback periods are riskier and more uncertain compared to shorter ones. If earning cash inflows by an investment takes longer, there’s the risk of no breakeven or profit gain. Considering capital increase and investments are, most of the times, based on estimates and future projections, you never know what the future holds for the income.
So, shorter payback periods are always preferred because if the firm can regain its initial price in cash, the investment automatically becomes more preferred and acceptable.
However, you should know that the cash payback period principle is not valid for every type of investment like it is with capital investments. The reason being that this calculation doesn’t take the time value of money into account– if money sits longer in an investment, it is worth less over time.
What Is the Formula?
To calculate the payback period, you have to use the following formula:
You will get a percentage from this formula. If you multiply this percentage by 365, you can get the amount of time it will take for an investment to generate enough money to pay for itself.
However, considering that not every project lasts the exact length of a year, you can use this equation for any period of income. That being said, you could use semi-annual, monthly and even two-year cash inflow periods.
To conclude, a payback period determines the amount of time it takes for an investment or project to pay for itself. Management should use this calculation to their advantage and take it into consideration when planning their development and investments for their business.