Having too much business to handle seems like a great problem to have, but picking and choosing which projects work best for your business can add extra challenges. When you need to decide between mutually exclusive projects, calculating the payback period can help you evaluate the risk of each undertaking. This capital budgeting tool analyzes the amount of time before a project breaks even. It also examines future cash flow and the timing of benefits to determine the risk of each individual project.
When to Use Payback Period in Capital Budgeting
The payback period proves most helpful when you need to choose between multiple capital projects. Usually, it’s appropriate for situations where your small business places more importance on liquidity, or cash flow, than profitability, or future returns. Before you can use this method, you need to have a way to estimate your company’s future cash flow.
The payback period method works best when you use it in conjunction with other capital investment tools, such as net present value or internal rate of return. Although this capital budgeting calculation improves your project selection process, it serves more as a supplement to a long-term profitability analysis, which helps you forecast how much you stand to make in periods lasting more than a year. In addition, you should only apply payback period method to single departments — the method isn’t designed to cover a project’s advantages or disadvantages to your entire organization.
Formula for Payback Period
To calculate the payback period, divide your initial cash outlay for a project by the anticipated cash inflows or the reductions of cash outflows. The result equals the amount of time you need to earn back the money you invest in the project at the start. This return on investment comes in different forms, including actual revenue or expense reductions. If you spend money to upgrade equipment, for example, your ROI might be more efficient operations and increases in productivity.
Using the Payback Period to Make Capital Decisions
Imagine you have $45,000 set aside for a capital project. One project requires all the $45,000 as an initial investment, but you expect it to reduce your cash outflows by $15,000 per year over the next four years. A second project requires $40,000 as an initial investment, and you expect it to produce cash inflows of $10,000 for the next six years.
The payback method of capital budgeting shows that the first project has a payback period of three years, or your $45,000 investment divided by $15,000 per year of savings. The second project has a payback period of four years, or $40,000 investment divided by $10,000 per year of savings. In this case, the first project has the shorter payback period, making it a more attractive option. In other words, you recover your initial investment after three years rather than four. When you use this calculation, you can disregard cash flow after the payback period.
Advantages and Disadvantages of the Payback Period Method
Simplicity proves the main advantage of the payback period method. Your main challenge comes down to estimating cash flow — after that, the calculation proves simple. Since this method considers the length of a project, it helps you decide whether or not the project might become obsolete. After all, longer projects have more risk. The payback period method favors shorter projects, so it incorporates the risk your company might not receive all the projected cash flow.
As with any method, some drawbacks exist to the payback period calculation. The major flaw in this equation is that it doesn’t consider cash flow beyond the break-even point. If you’re considering a project with slower cash flows, it might not perform well in the payback period, but it may have larger returns overall.
What’s more, the payback period doesn’t factor in the time value of money. Usually, you can adjust for this by using a discounted payback period method. Additionally, this method relies very heavily on forecast cash flow calculations obsolescence, but the uncertainty of these figures can cause major miscalculations.
Payback period offers small businesses a useful project-selection tool, particularly when you use it in combination with other calculations. With the right accounting software, you can track expenses and estimate cash flow accurately to improve your assessment. More than 4.3 million customers use QuickBooks Online. Join them today to help your business thrive for free.