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Accounting terms explained in a simple way

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  1. Cash flow
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  3. Time Value of Money (TVM)

Payback period - What is a payback period?

A payback period is the amount of time needed to earn back the cost of an investment.

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The length of time necessary for a payback period on an investment is something to strongly consider before embarking upon a project- because the longer this period happens to be, the longer this money is "lost" and the more it negatively it affects cash flow until the project breaks even, or begins to turn a profit.

What does the payback period mean?

Payback period is typically used to evaluate projects or investments before undergoing them, by evaluating the associated risk.

An investment can either have a short or long payback period. A shorter payback period means the investment will be ‘repaid’ fairly shortly, in other words, the cost of that investment will quickly be recovered by the cash flow that investment will generate.

Typically, a shorter payback period is considered better, since it means the investment’s risk level associated with the initial investment cost is only for a shorter period of time.

When is the payback period favourable?

In order to determine whether the payback period is favourable or not, management will determine the maximum desired payback period to recover the initial investment costs.

Depending on the calculated payback period of a project, management can decide to either accept or reject the project. An investment project will be accepted if the payback period is less than or equal to the management's maximum desired payback period.

The simple formula for determining a payback period is the following:

Payback period = Initial investment cost / cash inflow for that period

Payback period example

Payback period is usually expressed in years. You can calculate the payback period by accumulating the net cash flow from the the initial negative cash outflow, until the cumulative cash flow is a positive number. When the cumulative cash flow becomes positive, this is your payback year.

There are two methods to calculate the payback period, and this depends on whether your expected cash inflows are even (constant) or uneven (changing every year).

1. Payback period - even cash inflows

If cash inflows from the project are even, then the payback period is calculated by taking the initial investment cost divided by the annual cash inflow.

For example: Company A wants to invest in a new project. This project requires an initial investment of £30 000, and is expected to generate a cash flow of £5000 per year. Managements maximum desired payback period is 7 years.

Calculation:

  • £30,000 (initial cost) divided by the £5,000 (annual cash inflow) = 6

  • Therefore, the payback period for this project is 6 years

This means the payback period (6 years) is less than managements maximum desired payback period (7 years), so they should accept the project.

2. Payback period - uneven cash inflows

If cash inflows from the project are uneven, then we need to calculate the cumulative cash inflow, and use the following formula to compute the payback period:

Payback period = A + (B/C)

Where:

A = The last year with a negative cumulative cash flow

B = The absolute value of cumulative cash inflow at the end of Year A (the last year with a negative cumulative cash flow)

C = Total cash flow during the year after Year A

For example: Company B wants to invest in a new project, and managements maximum desired payback period is 3 years. The project requires an initial investment of £550 000, and is expected to generate the following cash inflows:

Year 1 = £75 000

Year 2 = £140 000

Year 3 = £200 000

Year 4 = £110 000

Year 5 = £60 000

Calculation:

  • Year 0 = - £550 000
  • Year 1 = £75 000 (- £550 000 + £75 000 = - £475 000)
  • Year 2 = £140 000 (- £475 000 + £140 000 = - £335 000)
  • Year 3 = £250 000 (- £335 000 + £250 000 = - £85 000)
  • Year 4 = £120 000 (- £85 000 + £120 000 = £35 000)
  • Year 5 = £60 000 (£35 000 + £60 000 = £95 000)

Payback Period = A + (B/C) Payback Period = Year 3 + (£85 000/£120 000) = 3,7 Therefore, the payback period for this project is 3,7 years.

This means the payback period (3,7 years) is more than managements maximum desired payback period (3 years), so they should reject the project.

Advantages and disadvantages to payback period method

Although the concept of a payback period is an easy one to get your head around, and the information you gain from it is useful in assessing whether a project is a good idea to take on, there are some definite up and downsides to using the method.

Advantages of using a payback period calculation:

  • Easy to understand and straightforward to calculate.
  • Risk is considered up front, and it is possible to get a clear picture rather quickly on whether the investment is a bad idea to begin with.

Disadvantages of using a payback period method:

  • Cash generated from the project after the agreed maximum payback period is not taken into account, which means that in some cases a project might be rejected if the payback period is the only time frame taken into account.
  • Requires an arbitrary cut-off point.
  • Time value of money (TVM) is not taken into account when calculating the payback period

What is ‘Time Value of Money’ (TVM)?

Time value of money (TVM) is the principle that an amount of money at a current point in time will be worth more at some point in the future. This is because of its budding earning potential (due to interest that can be earned the quicker it is received).

In the scenario of calculating a payback period, we are looking at projected returns on the investment over a number of months or years, and therefore disregarding what amount of interest could be made. Therefore, this might not give an accurate overall picture of what cash flows will actually be earned for the project.

What does payback period mean for my business?

For businesses, payback period can serve as a useful way to see how viable a project is. Before taking on a new project or investing the money for a new project, make sure that you are comfortable with the payback period you've set yourself.

If a project has the potential to generate new income, then it's worth considering however, only if you can break even - and even better if you can break even before the time limit set!