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What is payback and how is it calculated?

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  • Business, Company, Finance
  • 5 min
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In the world of finance, sound decision making is the fundamental pillar on which the success of any company is based.

Índice

Among the wide range of tools available to assess the viability of an investment, the payback, also known as the amortization period, has positioned itself as a key indicator due to its simplicity and practicality.

Throughout this article, we will not only delve into the concept of payback, but we will also guide you step-by-step in its calculation so that you can apply it accurately to your own financial projects.

What is payback?

Payback, in essence, allows us to determine the time it takes a company to recover the initial investment made in a specific project or asset. In other words, it tells us how long it takes to generate net cash flows equal to the amount invested at the beginning.

Its calculation is based on the division of the initial investment by the annual net cash flows generated by the project. This crucial information is obtained from the company’s financial statements, specifically the cash flow statement.

Why is payback important?

Payback has become a fundamental tool for financial decision making for a variety of reasons:

  • Simplicity: Its calculation is relatively simple and straightforward, which makes it an accessible indicator for anyone involved in investment evaluation.
  • Liquidity: Provides a clear view of the time required to recover the invested capital, which is very useful to assess the liquidity of the project and its impact on the company’s cash flow.
  • Initial assessment: This is an ideal indicator for a quick initial assessment of the viability of an investment, especially in the early stages of a project.
  • Comparison of projects: Allows to compare different investment projects in a simple and direct way, taking as a reference the payback time of the investment in each case.

How is payback calculated?

To calculate the payback of an investment, it is necessary to follow these steps:

Data collection

  • Initial investment: Refers to the total amount invested in the project at the beginning of the project.
  • Annual net cash flows: This is the net income generated by the project in each year, after deducting operating expenses and any additional investments.

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2. Payback calculation

The basic formula for calculating payback is as follows:

Payback = Initial investment / Net cash flows per year

Payback Calculation Example

Assume the following situation:

  • Initial investment: €10,000
  • Expected annual net income:
    • Year 1: €2,000
    • Year 2: €3,000
    • Year 3: €4,000
    • Year 4: €5,000
    • Year 5: €6,000

We want to calculate in how many years the initial investment will be recovered.

Step by step:

  1. Year 1:
    • Accumulated net income: €2,000
    • Remaining investment: €10,000 – €2,000 = €8,000
  2. Year 2:
    • Accumulated net income: €2,000 + €3,000 = €5,000
    • Remaining investment: €10,000 – €5,000 = €5,000
  3. Year 3:
    • Accumulated net income: €5,000 + €4,000 = €9,000
    • Remaining investment: €10,000 – €9,000 = €1,000
  4. Year 4:
    • Accumulated net income: €9,000 + €5,000 = €14,000
    • Remaining investment: €10,000 – €14,000 = -€4,000 (the investment has already been recovered)

The initial investment of €10,000 is recovered somewhere between the end of Year 3 and the beginning of Year 4. To be more precise, we calculate the fraction of Year 4 needed to recover the remaining €1,000:

  • Net annual income in Year 4: €5,000
  • Therefore, it is recovered in €1,000 / €5,000 = 0.2 years.

Result:

The payback period is 3 years and an additional 0.2 years, or 3 years and 2.4 months.

3. Interpretation of the result

The payback result is expressed in years. A low payback indicates that the investment is recovered quickly, which makes it more attractive. Conversely, a high payback means that it takes longer to recover the investment, which may imply a higher risk.

Limitations of payback

While payback is a useful tool for the initial evaluation of investments, it is important to consider its limitations:

  • It does not consider the time value of money: Payback does not take into account the fact that money received in the present has a greater value than money received in the future. This can lead to underestimating the profitability of projects that generate significant cash flows in later years.
  • It does not reflect total profitability: The payback does not provide information on the total profitability of the project, only the time it takes to recover the initial investment. For a more complete evaluation, it is recommended to use indicators such as the Net Present Value (NPV) or the Internal Rate of Return (IRR).
  • Sensitivity to cash flows: Payback is very sensitive to changes in projected cash flows. Small variations in revenue or expense estimates can have a significant impact on the payback result. Therefore, it is recommended that a sensitivity analysis be performed to evaluate the impact of payback under different possible scenarios. This involves considering various hypothetical cases where cash flows vary, either positively or negatively, and observing how this changes the payback result.

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Conclusion

Payback is a useful tool for the initial evaluation of investments, but it is important to consider its limitations and complement it with other financial indicators for a more complete decision making process.

At Stoamwe offer a SaaS software software that allows you to calculate the return on your investments quickly and easily, in addition to providing you with other relevant financial indicators and benefits. relevant benefits for the correct operation of your projects.

¡Contact us today today and find out how we can help you!

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