Determining a Payback Period

A payback period is the amount of time in which it will take a company to recover or pay back an investment.  This could pertain to the initial investment that a business owner puts toward a startup, contributed by a venture capital firm, a loan from a bank or the cost of launching a particular project.  For a startup, it’s important to know the payback period because technically, the company is not profitable until that point.  For a lender, it’s important to know how long it will take before they see a return on their investment. 

The payback period can be calculated by dividing the cost of the project by the annual cash inflow.  For example, if it will cost $100,000 to launch a project that is expected to generate $25,000 per year, the payback period is 4 years.

Sometimes you may have to estimate the income generated by the project, which therefore means your payback period will also be estimated.  Nevertheless, investors/lenders want to know this information so it’s good to include it in a business plan.  It’s also good information for the company in terms of managing expectations for the launch of a new division, product or startup as well as managing the company’s budget. 

This type of analysis can be very useful to a company that is making multiple investments in different areas.  Expenditures can get confusing when there’s a lot going on and determining the payback period of a particular investment helps to organize the flow of cash.  From a decision-making standpoint, determining the payback period could make the difference between proceeding with a plan or not, particularly if the payback period is too long. 

Even though the payback period doesn’t take into consideration the time value of money, it helps to measure risk which is an issue that all investors and entrepreneurs grapple with before making a decision to move forward with a business venture or project.  In its simplest form, determining a payback period is figuring out how long it will take to breakout even.  Every business owner wants to know when their company will become self-supporting.