Let’s say the net cash flow amount is expected to be higher, say $240,000 annually. The term is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, simple payback period upgrades, or other changes. For example, a compact fluorescent light bulb may be described as having a payback period of a certain number of years or operating hours, assuming certain costs.
This works well if cash flows are predictable or expected to be consistent over time, but otherwise this method may not be very accurate. The payback period is favored when a company is under liquidity constraints because it can show how long it should take to recover the money laid out for the project. If short-term cash flows are a concern, a short payback period may be more attractive than a longer-term investment that has a higher NPV. Getting repaid or recovering the initial cost of a project or investment should be achieved as quickly as it allows. However, not all projects and investments have the same time horizon, so the shortest possible payback period needs to be nested within the larger context of that time horizon.
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This means that it will actually take Jimmy longer than 6 years to get back his original investment. Cash flow is the inflow and outflow of cash or cash-equivalents of a project, an individual, an organization, or other entities. Positive cash flow that occurs during a period, such as revenue or accounts receivable means an increase in liquid assets. On the other hand, negative cash flow such as the payment for expenses, rent, and taxes indicate a decrease in liquid assets.
Moreover, it’s how long it takes for the cash flow of income from the investment to equal its initial cost. Payback period is used not only in financial industries, but also by businesses to calculate the rate of return on any new asset or technology upgrade. For example, a small business owner could calculate the payback period of installing solar panels to determine if they’re a cost-effective option. Previously we mentioned that companies look for the shortest payback periods.
It may be the deciding factor in whether you should go ahead with the purchase of that big-ticket asset, or hold off until your cash flow is better. Small businesses in particular can benefit from payback analysis simply by calculating the payback period of any investment they’re considering. The Payback Period Calculator can calculate payback periods, discounted payback periods, average returns, and schedules of investments. By the end of Year 3 the cumulative cash flow is still negative at £-200,000.
