If your business is considering making a big investment—perhaps buying a pricey piece of new equipment or launching a big new marketing campaign—you need to know whether it will increase revenue enough to justify the expense. One way to gauge the investment’s potential value is by determining the payback period, or the amount of time you need to earn back the money you spent.
Learn what you need to know about calculating the payback period and how to use it to help plan your business’s growth.
What is a payback period?
Payback period is how long it takes for you to recoup an initial investment’s cost based on the cash flows it generates. Typically, you measure a payback period in years and fractions of years.
Businesses use payback period calculations as part of their capital budgeting as they decide how and when to use resources in the most profitable way. Equity investors also calculate payback periods when considering investments in companies. It’s a relatively quick and easy way to assess investment opportunities as well as risks. It helps determine the cost of tying up money for years, waiting for the investment to become profitable, while forgoing other uses for the money.
The payback period is related to the breakeven point, the amount of output or cash earned from an investment to recover its initial cost. Generally, a shorter payback period is preferable because it means less time to reach the breakeven point and for the initial investment to become profitable.
How to calculate payback period
You can calculate the payback period for an initial investment in one of two ways: a simple division method, or a more complex but potentially more useful subtraction method.
Division method
In the division method, also called the averaging method, you divide the initial investment cost by the average annual cash flow the investment generates. The payback formula is:
Investment cost / Average annual cash flow = Payback period in years
This payback period method assumes that cash flows are regular and about the same each year, keeping the calculation simple.
For example, let’s say your print-on-demand business is looking at a $300,000 initial investment in new computer-guided printing equipment. You expect a steady cash flow of $100,000 per year from production with the new equipment. So the payback calculation looks like this:
$300,000 investment / $100,000 annual cash flow = 3 years
In other words, it will take three years to recoup the investment.
Subtraction method
The division method works fine if your annual cash flows are consistent. If your cash flows vary, you may want to use the subtraction method instead. Here, the formula successively subtracts each annual cash flow from the investment cost until the breakeven point is reached, between negative (outflows) and positive (inflows) flows of cash from the investment.
The business then calculates payback in whole and fractional years with the following formula:
Last year with negative cash flow + (Amount of cash flow for that year / Amount of cash flow the year after) = Cash balance
An example makes this clearer. Let’s say your print-on-demand business makes the following projections of irregular annual future cash flows from the $300,000 it spent on equipment:
Year 1: $50,000
Year 2: $75,000
Year 3: $100,000
Year 4: $125,000
Using the table below, the business can see that payback occurs between Year 3 and Year 4, when the cash balance, or net cash flow, goes from negative to positive.
| Time | Annual cash flow | Cash balance |
|
Year 1 |
$50,000 |
-$300,000 + $50,000 = -$250,000 |
|
Year 2 |
$75,000 |
-$250,000 + $75,000 = -$175,000 |
|
Year 3 |
$100,000 |
-$175,000 + $100,000 = -$75,000 |
|
Year 4 |
$125,000 |
-$75,000 + $125,000 = $50,000 |
To calculate a precise payback period, first divide the cash balance from the third year, which is the last year ending with a negative cash balance, by the annual cash flow of the fourth year.
75,000 / 125,000 = 0.6
The 0.6 represents the fraction of the fourth year with negative cash flow. Add 0.6 to 3, which represents the first three years of negative cash flow.
0.6 + 3 = 3.6
The payback period is 3.6 years.
Online payback period calculators can simplify the process.
Pros of payback period
Calculating a payback period offers some benefits, including:
Simplicity
The payback period formula can help you get a quick sense of whether the initial cost of an investment is worth pursuing. For example, you can use it to filter out investment proposals or growth opportunities with prolonged payback times, letting you focus on investments with a good payback period.
Easy comparisons
The payback period facilitates side-by-side analysis of two competing projects. If one has a shorter payback period than the other, it might be the better option.
Effective cash management
By providing a time horizon for recouping the investment, the payback calculation gives a business a marker to manage its cash flow toward the breakeven point. This can be important for a business operating under cash constraints.
Cons of payback period
- Limited time horizon
- Lacks profit or return calculation
- Overlooks time value of money
- Ignores capital-expense accounting
At the same time, a payback period calculation has some limitations:
Limited time horizon
The payback calculation only looks at the time period for recouping investment costs. It doesn’t take into account cash flows beyond the payback period. This is why business managers and investors can’t rely on the payback period alone when weighing different investments. Some investments may require more time to generate the anticipated higher cash flows.
Lacks profit or return calculation
The payback period calculation provides no information about the investment’s profitability, such as an expected rate of return. Proposed investments typically must show some minimum expected return for businesses and equity investors.
Overlooks time value of money
The time value of money concept states that a given sum of money is worth more today than in the future because the money has earning potential over time. Also, inflation can erode the money’s future value. Simple payback period calculations don’t account for the time value of money, which also neglects opportunity costs, or how you could otherwise use the money. A method known as discounted cash flows can provide a more accurate payback period calculation.
Ignores capital-expense accounting
The payback period treats the investment as a one-time cost. It doesn’t consider that capital spending for equipment or other large purchases is typically spread across a number of years, through an accounting process called depreciation.
Payback period calculation alternatives
Instead of using a payback period calculation, or to supplement it, businesses and investors could use the following tools to evaluate potential investments:
Net present value (NPV)
NPV calculates the sum of all expected cash flows of an investment, discounted by some required rate of return, minus the investment cost. NPV informs managers how much value an investment could bring to their businesses after accounting for the time value of money. A positive NPV means the investment would be profitable and worth pursuing, while a negative NPV means it’s likely to be unprofitable and should be avoided.
For example, let’s say your print-on-demand business estimates the $300,000 investment in new printing equipment will have a useful life of six years, including the payback period. In addition to the four annual estimated cash flows in the table above, it projects a Year 5 cash flow of $150,000, and a Year 6 cash flow of $250,000. It decides that a discount rate of 7% is appropriate, based on its expectations for inflation and a return from investing in a safe alternative such as government bonds. It treats the discount rate as its cost of capital.
Using the net NVP formula, the printing business can determine the expected cash inflows to have a net present value of $263,000 in excess of the $300,000 investment in equipment. Positive NPV means the investment would be profitable.
Internal rate of return (IRR)
Businesses use internal rate of return (IRR) to estimate the profitability of a potential investment. While NPV estimates the dollar value of a potential investment, IRR is the expected compound annual rate of return on the investment. Business managers and investors look for an internal rate of return that’s higher than the discount rate; together with positive NPV, it signals an investment is worthwhile.
Using an online IRR calculator, the print-on-demand business can plug in the $300,000 investment cost and the six expected annual cash inflows from the new equipment. The result is an estimated annual IRR of 25.6%—well above the business’s 7% discount rate, meaning the new printing equipment is an attractive investment.
Calculating payback period FAQ
What is the formula for calculating payback period?
The simplest formula for payback period is: Investment cost / Average annual cash flow = Payback period in years. This formula divides the investment cost by the average annual cash flow from the investment to determine the number of years necessary to recover the investment. This averaging formula depends on consistent annual cash flows.
How do you determine payback period?
Payback period is determined by how long an investment takes to break even—when the cumulative cash flow from the investment equals its initial cost.
Why do you calculate payback?
Businesses and investors use the payback period to estimate how long it will take to recoup the cost of an initial investment. For example, a business wants a payback not to exceed three years on a possible investment, but cash-flow projections indicate a five-year payback period. The business could decide not to proceed, seek an alternative investment with a lower payback period, or do some other financial analysis, such as net present value, to see if the investment is still worthwhile.
