Understanding what payback is is crucial for the success of any entrepreneur or investor, because it’s a metric that allows you to accurately and efficiently evaluate the return on your investments.
In this article, you will learn everything about this indicator, how to calculate it correctly, and why it’s an essential tool for planning and analyzing your investments and financial decisions. Check it out!
What is payback?
Payback is a financial calculation used to determine how long it will take for a project or investment to pay for itself. This tool also allows you to assess the risks and viability of any type of investment.
With this information, investors and entrepreneurs can make more informed and secure decisions about how and where to allocate their resources, significantly reducing short- and medium-term risks.
What is payback used for?
When we talk about investment and financial management, this is a metric that serves several important purposes. Check out some of the main ones below:
- Assessing Investment Viability: As mentioned above, payback is excellent for determining if an investment is viable, indicating how long it will take to recoup the investment.
- Risk Management: By showing the time it will take to recover the invested value, payback becomes an excellent risk management tool. After all, the faster the return, the lower the risks.
- Project Comparison: This indicator also makes it easier to compare different projects or ventures, helping to identify which ones offer a faster return.
- Decision Making: Entrepreneurs and investors often use payback as a strategic way to make more informed decisions about their investments and resource allocation.
- Financial Planning: Payback also allows you to plan cash flows and ensure that your company’s liquidity is not compromised by any of your investments.
Payback and its relationship with cash flow.
To learn what payback is and how to calculate it, it’s important to understand its connection to a company’s cash flow. After all, we need to know how much revenue an investment will generate monthly to determine how long it will take to recover the initial investment.
It’s essential that your company’s financial management is up-to-date, as the calculation of your payback and your investment decisions can change significantly depending on your revenue and expense sources.
How to calculate payback?
There are basically two types of payback that can be calculated in a company: simple and discounted. Below, we will explain the differences and how to calculate each one, check it out:
Simple Payback
Calculating simple payback is very easy; you just need to take the investment amount and divide it by the average cash flow for the period being analyzed. The formula looks like this:
Simple Payback = Initial Investment / Average Cash Flow Balance for the Period
For example, let’s suppose a company bought new equipment costing R$120,000 to increase its production. According to forecasts, the equipment should generate approximately R$6,000 in revenue monthly, after deducting maintenance and depreciation costs.
To find out how long it will take for the equipment to pay for itself, simply use the formula above, substituting the values:
Simple Payback = R$120,000 / R$6,000
Simple Payback = 20 Months
In other words, the company will need 20 months (1 year and 8 months) to recover the investment made in the new equipment and start making a profit.
Although easy and efficient in some scenarios, the simple payback calculation is somewhat limited because it doesn’t take into account several factors, such as variable income and the devaluation of money.
Discounted Payback
Calculating the discounted payback period can give us a more realistic picture because it considers a discount rate that adjusts values over time. However, to learn how to calculate it, we need to learn two new concepts:
- Minimum Attractive Rate of Return (MARR): The MARR is a rate used to assess the viability and define the minimum expected return of an investment or project. It is usually based on a rate such as the SELIC rate or other benchmarks of your choice.
- Net Present Value (NPV): This is a financial metric that calculates the present value of cash flows from future values, already discounting the MARR. In other words, it helps determine if an investment is worthwhile when considering the time value of money.
To find the discounted payback period, it is first necessary to use the formula below to determine the NPV:
NPV = Cash Flow (CF) / (1 + MARR)¹
Using the same example as before, let’s imagine that the company wants to calculate the payback period discounted based on a 20-month cash flow and a MARR (Minimum Acceptable Rate of Return) of 20%.
See the calculation below:
NPV = R$6,000.00 / (1+0.2)¹
NPV = R$6,000.00 / 1.20
NPV = R$5,000.00
Now that we have found the NPV, let’s apply this value to the discounted payback formula:
Discounted Payback = Initial Investment / Discounted Cash Flow
Discounted Payback = R$120,000 / R$5,000
Discounted Payback = 24 Months
Therefore, by calculating the discounted payback, we can see that it will take 24 months for the company to recoup the initial investment made in the equipment.
How to analyze the Payback result
As we have mentioned several times throughout the article, payback is based on the results of accumulated cash flow. If the company does not accurately control its monthly revenues and expenses, the payback calculation will not be accurate or reliable.
It is very common for new projects and ventures to show a financial deficit in the first few months, and over time, the values tend to stabilize and generate a positive result.
In other words, payback is the period of time required for the sum of new revenues to equal the amount initially invested.
ROI
There are several other indicators that need to be considered when analyzing the viability of an investment. One of the most important is ROI, which helps us evaluate the efficiency or profitability of an investment.
Return on Investment (ROI) is always expressed as a percentage and its function is to measure the return and profitability of different investments. Both indicators can be used; it all depends on the company’s needs at that moment.
Advantages and Disadvantages of Using Payback
Payback, like any other indicator, offers advantages and disadvantages when evaluating and analyzing investments. Let’s talk a little about the positive and negative aspects of this tool:
Positive points:
- It features a simple formula that can be easily applied in different situations;
- It shows you how long it will take for an investment, project, or venture to generate a return;
- It’s a strategic tool that assists in decision-making, reducing risks and resource losses;
- Ideal for evaluating short-term investments and small projects where a quick return is needed.
Negative points:
- It is not very compatible with large companies and more complex projects;
- It does not consider returns after the initial investment has already been recovered;
- Payback is not able to measure the total profitability of a project or venture, only the speed of investment recovery.
However, this is still a very valuable and useful indicator, provided it is used correctly, in isolated cases and, preferably, in conjunction with other metrics and indicators such as ROI, for example.
Have you learned what payback is and how to calculate it?
We hope our article has helped you understand what payback is, how to calculate it, and how this indicator is an important tool for making more informed decisions about your company’s investments.