## Payback Period (Payback Method)

**Payback period** is the financial budgeting method or capital budgeting method. It calculates the required number of days for investment to produce cash flow equal to the original cost of the investment. In other words, it measures the time of investment to earn enough money for the payment of itself or breakeven. For the analyzing of the risk on time base, this is the important measurement for the management.

#### Definition: What is the Payback Period?

If the investment takes much time to recoup its original amount then such type of investment will be a risky investment.

If the investment has a long payback period then it is said to be a less lucrative investment.

But with short time payback period company get payback sooner and can invest this cash into other operations of the company.

Longterm investment can’t be used for reinvestment as short term use by the company for reinvestment.

For the selection of desired payback management use the calculation of payback by using the below formula.

## Formula

Payback period formula can be calculated by dividing the project cost by the annual cash inflows as

**Payback period = Project Cost/ Annual Cash Inflows**

By using the payback period calculator answer of the above formula will be in percentage form.

To arrive the number of days we need to multiply the 365, the company get a result of earning to pay itself.

For different periods like quarters, the semi-annual, annual, 2years project you can use this calculation.

## Example

John has a body shop. For the invest in the new equipment, he has 10,000 dollars.

In order to save the labour hour, John has the option to purchase the buffing wheel or bigger stand blaster to fit the part of the car.

He estimates that from this he can save 10 labour hours. Currently, John pays 25 dollars per hour to his finishing personnel.

Buffer generate 250 dollars per week which is the good enough income to pay for in 40week. Shop of John has the following payback calculation.

**40 week = $10,000/$250 per week**

If John purchases sand blaster then he can save 100 $ per week but the payback period for sandblaster is greater so he gives priority to buffer wheel for purchasing.

## Analysis

Management use payback period calculation to find how quickly the company gets payback on its investment.

In the above example, John has 2 choices of payback which are 100 weeks or 40 weeks. John chooses the 40-week investment because he earned money quickly from his investment and can reinvest this money again for their business.

Longer payback period is riskier as compared to the shorter payback. If the equipment of the company is break and company has a longer payback period then it is difficult for the company if it has not enough money to repair the equipment.

But with the short payback period the company collect the cash quickly and easily repair its equipment.

**For more Financial Ratio Check: **

**Operating leverage**

**Accounts payable turnover ratio**

Learn about

Financial Ratios, Banking and Finance and feel better.

## Leave a Reply