When it comes to running a business and maximizing the finances, there are many routes that one can take for budgeting. As there are always finite and limited budgets and resources, managers must make tough decisions on what investments are going to be worth it, and how long it will take. The “payback period method” is a way for a business to figure out how cash flow from different projects would come in, and which one would have the quickest return of initial investment, called the “payback period.”
Advantages of Payback Period
1. It Is a Simple Process.
One of the biggest advantages of using the payback period method is the simplicity of it. You base your decision on how quickly an investment is going to pay itself back, and that is done through forecasted cash flow. If you have three different projects that will cost you the exact same amount, the decision can be as easy as the project that will return the initial investment the fastest. For managers that are struggling to make an investment decision, this can be a great way to do it.
2. Fewer Numbers to Crunch.
As the payback period method is loved for its simplicity, it also extends to every aspect of the equation, naturally. For budgeting using this method, management will not have any complicated accounting or math that they will have to do. It can be as simple as a monthly return on the investment divided by the initial investment itself. While it is not going to account for every available variable, it is a very easy way to do a basic comparison.
3. Can Help Small Businesses.
Small businesses are going to have very limited funds to be able to invest in projects, so they must be extremely careful with their spending. This method of capital budgeting is a great way for a small business to easily decide what project is going to pay off the most. Sometimes for a small business, you must look solely at the profit and cash flow to be able to grow, and the payback period method can help you make solid investments.
4. Reinvest Earnings Faster.
If a business is looking to recoup their investments so they can continuously keep reinvesting and growing, this method is going to make things quick and easy. You are able to see which investments are going to pay you back the fastest, or most efficiently, and use this information to invest in the right things. If it is all about growing your business, you want to constantly have your money working for you through the right investment opportunities.
5. Can Tip the Scales for a Difficult Decision.
Sometimes as a business manager, it can seem downright impossible to choose between multiple prospective projects or investments. There can be issues where projects look so similar in scope and ability that choosing is going to be difficult without some solid numbers to back it up. The payback period will be able to show exactly which investment is going to be better based on ROI, which should make the decision easier. When there is not much else to differentiate multiple projects, a manager is going to need all the information and help he/she can get to make a decision.
6. Keeps Financial Liquidity.
In the world of business, it is utterly essential that you have the liquid capital to be able to run day-to-day operations and to make investments in the future of the company. A business can quickly get themselves into trouble if they have too much of their money tied up in investments with no way of quickly getting at it. The payback period method will help by showing management the right investments to focus on to keep liquidity in the business for further growth.
7. Can Prevent Major Losses.
Nothing is going to hurt small or medium businesses more than a massive loss on an investment. Unless you are at the top of your industry, there are always going to be tight budgets and financial constraints, and any big losses could mean major issues. With the payback period method, a business stakeholder is able to have an understanding of what investments are going to be lower risk and have a shorter time to break even, so this risk of big losses will be at a minimum.
8. Manage Multiple Options.
Depending on the type of business being run, there could be countless opportunities for investments and different projects. If you were a manager that had 20 different proposals to look and analyze, it is going to be difficult to figure out which ones to focus on. This can be even more so if you have to choose more than one investment. If you use the payback period method, it will give you a basic understanding of how the projects rank so you can choose the appropriate ones.
9. Short-Term and Long-Term Opportunities.
Not every business is going to want to invest in the short-term to get their money back as quickly as they can. Investment is also a long-term game, and the payback period method is going to show managers how a particular project will likely pay off over time. Some projects are going to pay off faster upfront, and others are a waiting game. It all depends on what your business is looking to do.
Disadvantages of Payback Period
1. Only Focuses on Payback Period.
There are some very big issues to observe with a payback period method, the first being that it only looks at cash flow for a certain time frame. If a business is just looking to see how quickly they can break even on their investment, this is fine, but that is certainly not always the case. The return on investment, after the initial investment is paid back, will not be a factor in these scores, and that can be very short-sighted.
2. Short-Term Focused Budgets.
Along with the fact that the payback period scores only focus on the initial return of the investment, it is a naturally short-termed focused budgeting technique. For any business that is looking to invest, recoup, and reinvest as fast as they can, this will work great. However, if your business is looking for a more long-term approach to project investment, the payback period method has some major shortcomings. It isn’t always going to be about how fast you can get your money back.
3. It Doesn’t Look at the Time Value of Investments.
This budgeting tactic is purely focused on short-term cash flow and getting the fastest possible return, so it misses a lot of other considerations. The value of money can vary over time, especially when you are talking about steady, long-term investments. A dollar that you invest today is not going to be worth the same as one invested 20 years ago. The payback period method ignores everything after the initial investment is recouped by the business.
4. Time Value of Money Is Ignored.
When talking about the time value of money, it assumes that money coming in sooner is going to be more valuable as it can be used to make more. The payback period method completely ignores the time value of money, whether that is a positive or a negative thing for the project and business. If a business only looks at one factor, then potentially promising investments can be missed.
5. Payback Period Is Not Realistic as the Only Measurement.
There is some usefulness to this method, especially in quick-moving industries with a lot of rapid change. The problem for most businesses is that they need to have a better balance of projects and investments so that their short, mid, and long-term needs are all taken care of. No business is going to be able to rely on this method for their investment opportunities if they want to have a stable future ahead. It is always better to use a variety of methods to make important decisions.
6. Doesn’t Look at Overall Profit.
This can be a major red flag for a lot of managers looking to improve their business. The profitability of a project, either short-term or long-term, is not considered at all, and this cannot be ignored by a good manager. You must be able to show profitability on a project, and the payback period method does not consider this important metric.
7. Only Short-Term Cash Flow Is Considered.
The payback period method really is a short-term only type of budgeting. If your company is concerned at all about cash flow for the business over time, this method is not going to give you any information to work with. As every project is going to provide cash flow on a different schedule, it is going to be impossible to make any but the most basic decisions based on this method. A business needs to know what kind of cash flow they should expect from their investments for the entire length of the project.
8. Too Simple for Most Investments.
Business investments, in general, are far from simple endeavors, even at the best of times. There are so many different factors that need to be evaluated and accounted for, that such a simple form of measurement is not going to be enough for most projects. For a business to truly understand what a potential project can do for them they must have more information than just how fast the initial investment can be paid back. Short-term cash flow is only a small part of the equation and should not be the only goal of a project.
9. Investments Are Not Assessed Properly.
When this type of budget is used for a project, it puts a lot of weight on the cash flow in the short-term. This also means that the entire evaluation is going to be weighted towards capitalizing on the short-term gains. However, in certain cases, it may be smarter to look at longer-term cash flow. Unfortunately, this method can obscure or manipulate long-term assessments and therefore can make some projects look more viable than they really are.
While there is no perfect way to handle accounting, investments, and budgeting in a business, there are certainly some methods that are going to be better than others. The payback period method does have some validity in certain industries with short-term growth, but there are too many factors that need to be considered for it to be a go-to method for most businesses.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.