What It Is and How to Interpret Payback

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What is: O Payback is one of the most used indicators in the return analysis of projects, together with the Net Present Value (NPV) and Internal Rate of Return (IRR). It will indicate the time needed for the accumulated profit generated to equal the initial investment. That is, it is demonstrated in units of time: days, months, years. Everyday we hear of it when someone says "you're going to get your money back in 18 months."

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Economic Feasibility Study Sheet

What are the advantages of using payback?

Unlike the calculation of NPV or IRR, payback has the characteristic of worrying about the liquidity term of the investment, that is, how long you will have that amount back in your pocket. So it brings comparative benefits like:

  1. Liquidity risk assessment
  2. Indicator of their financial mobility
  3. It indicates its capacity to make new investments already with the results of this
  4. Encourages better definition of seed capital
  5. Strengthens the importance of cost management

How to calculate payback?

O Payback is a very simple indicator to be found. However, there is also a somewhat more complex method called Payback Discounted. In this case first case, we will see how to find the Payback Simple. Then we will do the same calculation but using the discounted method.

First of all, you need to have a free cash flow accumulated. That means the sum of all the cash flows of your projection from start to finish. Usually, in new projects, the first months are negative and then with the accumulation of the positive operating result, this value becomes definitely positive. Let's use a simple flow like the one below:

free cash flow

The above flow indicates that in the first two months, the project was loss and the free cash flow was in -R $ 30.000,00. This was the lowest figure in our flow, which is probably close to the initial capital invested, because if the company did not close with this result, it certainly had planned a reserve.

After the third month, the company became operationally profitable and began to "return" capital. That means she stopped using the reserve box and actually generated cash for the deal. As the trend continued, in the fifth month the accumulated free cash flow was positive, indicating that all the money invested had already been recovered. It is precisely this month that the project reached its Payback.

In a more extensive flow, you can use the Excel CONTSE function and use the criteria less than zero (<0) and add with 1 at the end to get the next period. In this case, it would count the first 4 months that were negative and add up with 1 to point precisely to the 5 month.

Applying Discounted Payback

Discounted payback is a somewhat more complex method, since it involves the same logic of NPV calculation, but with the purpose of setting up a more accurate flow economically. In it, you will have to bring each of the months to present value. Thus, you will get the real notion of the value of money over time. Let's look at the example. The above flow would look like this:

What is and How to Interpret 1 Payback

We can notes that the values ​​of each flow, brought to present value gets a bit lower over time, this is because money is worth more than future money. In this case, we used a 12% rate per month and what happens is that the payback that used to happen in the month 5 now only occurs in the month 6!

When to use Simple and Discounted Payback

In virtually any investment, we think about the return of our money, most of the time we use the simple payback for its simplicity and that is without doubt its greater strength. Therefore, 90% of times it is the best way out, especially when they are simpler investments and with shorter deadlines and risks. With it, you get a very good approximation of the period it will take for your money to come back.

Therefore, the discounted payback is only worth being calculated when we are thinking of more voluminous investments with more complexity and money involved, because in these cases, the difference of a few months in the return can represent in significant amounts. In addition, since there is no formula in Excel for calculating payback, it must have made the hand, which gives a little more work.

This post clarified how to get and interpret the Payback of your business? Here at LUZ, we offer a variety of management tools for companies, including Excel worksheet ready for feasibility study of projects!

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