Determining payback periods: How to plan for startup success
Individual entrepreneurs, small-to medium-sized businesses and large corporations invest money into their operations with the goal of getting paid back. Furthermore, they hope their revenue will see improvement.
The point of investing is to excel beyond your original financial status. It can be risky, but it’s often worthwhile.
Here, we’ll explore what a payback period is, outline investment appraisal techniques and show how they help you plan for startup success.
What is a payback period?
A payback period is the time it takes to earn back the money you put into an investment. In other words, it’s the length of time required to reach a break-even point.
Invested money is intended to be earned back — and the shorter the payback period method, the better.
As a startup owner who’s likely under some form of financial restriction, you’ll want to aim for a shorter return period for any investment. This will give you room to make future investments that will ultimately increase your revenue.
How to calculate payback period
So, how do you work out a payback period?
Investors and other financial professionals often calculate payback periods before making investment decisions. You should know your startup’s return on investment (ROI) before investing anything. But more specifically, you should know how long it’ll take to gain back your money.
Calculating your payback period involves determining how long it’ll take to recover any initial or overall investment-related costs. And this information is especially useful when an investor must make a quick judgement about a venture. When push comes to shove, it’s a highly reliable metric to consider before making any decision.
Now, you might be wondering how to calculate payback period. Here’s the payback period formula:
Payback period = (the cost of your investment) ÷ (average annual cash flow)
Example of payback period
To better understand how all this works, let’s explore an example of payback period.
Imagine a business invests USD2 million into a particular project that’s expected to save its operations about USD500,000 annually. When you divide the cost of your investment (USD2 million) by your average annual cash flow savings (USD500,000), the total is 4.
Four represents the number of years it will take for you to earn back your original investment — your payback period.
For comparison, let’s consider another example. Let’s say your company invests USD1 million, which is expected to save you around USD400,000 annually. When you divide your investment (USD1 million) by your annual cash flow savings (USD400,000), you end up with 2.5.
This means your payback period totals two and a half years. So, based solely on a shorter payback period, the second example investment is better than the first.
So, what is a good payback period? Overall, your startup’s plan for success should involve short payback periods. The longer your payback periods are, the less desirable the investment is.
Here’s one more example. If you buy solar panels that cost USD10,000, and your utility savings are USD200 monthly, you would save USD2,400 yearly.
To calculate your payback period, divide your USD10,000 solar investment by USD2,400, which equals 4.2. This means your payback period is a little over four years.
Investment appraisal techniques
Another term for investment appraisal techniques is “capital budgeting techniques.” Project capital budgeting is a main focus for corporate finance. And it’s also one of financial analysts’ key activities.
But what is investment appraisal (i.e. capital budgeting)? It’s the process of finding the value of different investments. You can analyse your project-based investments and then compare them to determine the best value. From there, you can decide the best course of action for your startup.
Analysts often determine payback periods to decide the value of a project and its investment. But the payback period isn’t the only useful technique to decide project and investment value.
In fact, analysts use several appraisal techniques for project investment comparison. Each appraisal technique looks at the project from a different perspective to provide insight into its profitability.
Payback period: This is the time it takes for a project to regain the cost of its original investment.
Accounting rate of return: This is the net accounting profit earned from an investment. It’s presented as a percentage of a capital investment.
Net present value: This is the total amount of discounted future cash flowing in and out as it relates to a project — the sum.
Internal rate of return: This joins the discounted future return and the initial investment.
Profitability index: This defines how much money you earn per dollar of an initial investment.
Discounted payback period: This is a calculation based on your discounted future cash flow.
Advantages and disadvantages of payback period
There are several advantages and disadvantages of using payback periods to determine your investment strategy.
The main advantage of using the payback period formula is that it’s useful for your startup’s financial and capital budgeting. But you can also apply it to other industries.
Let’s imagine your business wants to invest in a software as a service (SaaS) tool such as Xero. Before going through with this decision, you should calculate your return on investment (ROI) for the new tool. When doing so, include the purchase cost (or in this case, the monthly subscription cost) and any other costs relevant to upgrading your business’s software that may be needed.
The payback period metric allows you to determine whether a project investment has a short or long horizon. And to benefit your startup, you can make a more informed decision on what investments to pursue without waiting too long to earn back your original investment funds.
However, the payback period metric has disadvantages. The payback period formula allows you to make a simple and quick calculation. But it doesn’t account for any future effects, such as inflation, time value of money and any financial complexities with unequal cash flow over a particular period.
This is where the discounted payback period comes into play. It helps people and startups account for certain shortcomings. The simple payback period formula is favourable overall, but the discounted payback period formula helps you determine whether an investment is particularly unfavourable.
Payback period vs discounted payback period
For clarity in this comparison, calculating a payback period is how your startup can determine when to expect recovered investment costs. So in terms of capital budget accounting, this means the time required to see an ROI that’s equal to the sum of your initial investment.
As for the discounted payback period, this metric also determines the time needed to recover your original investment. But it also accounts for the value of your time as it pertains to money.
Here is the discounted payback period formula:
Discounted payback period = y + abs(n) / p
“y” is the period that comes after the period where cash flow becomes positive.
“p” is the discounted value of cash flow in the period that cash flow is equal to or greater than zero.
“abs(n)” is the absolute value of the cumulative discounted cash flow in the “y” period.
So, let’s say your startup wants to pursue a project that requires USD6,000. You expect the project to earn USD2,000 per period for the next four periods. The appropriate discount rate is 5%.
This means your discounted payback period calculation should be minus the original investment (USD6,000) in the starting period. When the next period begins, you add USD2,000 (this is the cash inflow).
You then take the current interbank rate (USD2.83 for the US as of now) and divide it by your expected period return. So, USD2,000 divided by USD2.83 equals USD706.71.
After the first period, your project requires USD6,000 minus USD706.71. Therefore, you need USD5,293.29 to break even on your investment.
Then, after discounted cash flows of USD2,000/(USD2.83)2 in period two, then to the third power in period three and the fourth power in period four, you’ll end up with a discounted payback period metric that shows your project’s final balance.
How to use payback period in your startup
Using the payback period metric in your startup is ideal when your business has liquidity constraints. The payback period metric shows how long it will take you to recover any money you spend on projects.
Whether your projects are small or large, knowing when you’ll regain money is key. Because startups generally have financial constraints, these waiting periods matter.
Your startup might be actively seeking capital from venture capitalists or crowdfunding. Until you receive that capital, you’re working with your own funds. Waiting too long to earn back from your investments could hurt your business and its operational flow.
So, to plan for startup success, aim for shorter payback periods. For startups, these shorter periods typically work better than longer-term investments when considering your net present value.
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