How to Calculate Payback Periods: An Overview

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If you plan to invest in new projects, research and development or any other capital project for your business, understanding the payback period is crucial. Without a solid idea of how long it’ll take for your company to break even on your investment, it will be challenging to structure a useable budgetfor your business.Learn what a payback period is, understand the reasons for calculating a payback period, know how to calculate a payback period and review answers to frequently asked questions about payback periods.

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What is a payback period?

A payback period is the amount of time it will take for your company to regain the initial investment put into a project. Calculating the payback period gives you the break-even point or the point at which you’ll no longer be in debt from your investment before you earn any revenue or profit. Ideally, the payback period for an investment is relatively short, so you don’t spend much time in debt.

While it’s most common for companies in the financial sector to calculate the payback period for capital projects, businesses in other industries and even individuals can use this metric, too, to assess the value of their investments.

Reasons for calculating a payback period

Most commonly, companies calculate the payback period for capital projects. This type of project is usually defined as an investment in an asset that will take more than one year to acquire. Many companies track expenditures for investments that will take less than a year to reach the break-even point differently than long-term capital projects. Knowing the general time frame of a project will help you determine whether to calculate the payback period.

Calculating the payback period

You can calculate the payback period using several different methods. Most businesses prefer to use a simple metric that offers an approximation rather than a more complex formula that requires the use of software. The simple formula often provides enough information for businesses to make a decision about moving forward with the investment.

Use this formula to calculate the payback period for your capital project or other long-term business investment:

(Cost of investment / annual cash inflow from the project) = payback period

Substitute the actual figures for the cost of the investment and the projected annual returns from the investment to find the payback period.

Example:

Henry’s Towing and Repair wants to invest in a lift for their repair shop. The model they’re considering costs $20,000. However, they anticipate they can perform considerably more business with the additional lift, so their cash inflow from the investment would be $7,000 per year. They use the simple payback period formula to determine when they’ll break even and begin making a profit from their investment:

$20,000 / $7,000 = 2.9 years

Based on their projected cash inflow from the new lift, Henry’s Towing and Repair can expect the payback period to last 2.9 years.

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Frequently asked questions about payback periods

You can calculate payback period in several ways. Most companies start with a simple formula, based on cash inflow projections, to get a sense of how long the payback period will last. However, some companies prefer a more intensive and complex formula that provides a more accurate payback period answer. This metric involves the use of spreadsheet software for assistance, so there’s no single formula to use, but rather a series of formulas that arrive at a single payback period.

While there’s no specific number to determine whether a payback period is acceptable or not, it’s important to understand that while in the payback period, you’ll likely be in debt and won’t have access to much, if any, additional capital to invest in other projects or pay down any outstanding debts. For this reason, it can be helpful to use the payback period formula comparatively to find the shortest payback period out of several options.

Calculating the payback period for uneven, or cumulative cash flows, is a bit more complex than even cash flows. Rather than expecting the same level of return on the investment for every year after the initial investment, the return increases over time. Subtract the projected annual return from the initial investment cost for every year to discover at what point you can expect to break even and turn a profit.