Categorized | finance

The spreadsheet formulas every entrepreneur should know, Part 5: What is payback?

Pen and Excel bar graph
The Series
Introduction
1.) Internal Rate of Return
1a.) Modified Internal Rate of Return
2.) Net present value
3.) Payback (What Is Payback?, Spreadsheet Payback, Discounted Payback, Spreadsheet Discounted Payback)
4.) Average
5.) Standard deviation
Bonus!) Excel Solver

Our epic little mini-series on must-know spreadsheet formulas has covered some pretty advanced topics, mind-benders like the internal rate of return and net present value, painful but powerful math for discovering the financial prospects of a startup or business project. In comparison to these textbook beasties, calculating a payback period is literally a walk in the math park. Really — the only business math harder to calculate than payback is counting your money. And, like IRR’s and present values, startup investors, including venture capitalists, set a great deal of store by paybacks — an attractive (that is, short) payback period is yet another reason for folks with money to throw a bit your way.

Because payback is both critically important and mindlessly simple, you’d think it would be easy to do on your spreadsheet, right? Well, see, you’re trapped by your earthling way of thinking there. Spreadsheet designers in their infinite wisdom have transported payback to the twelfth dimension, so setting up a formula to automatically determine the payback period for your prospective business or project financials requires a bit of zigging and sagging.

Which is why this is such a great blog post. Because we’re going to do all the zigging and zagging for you and give you a nice, clean formula that you can paste into your financial projections.


Payback
So what’s a payback?

Payback period is the amount of time it takes to recoup an investment.

For fixed maturity investments in which cash flows represent only a fraction of the investment (as interest or dividends), payback is not a relevant calculation. The calculation only has relevance when you’re dealing with periodic cash flows that represent a significant fraction of the investment. Now, the investment can be a one-time, initial investment, or be a periodic infusion of capital. A payback tells you when the positive cash flows (the returns on your investment) have paid back the negative (investment) cash flows.

Let’s say you invest ten thousand dollars in your startup. In the first year (Year 0 – Year 1), you lose $1,000 and you have to inject another $1,000 into your startup to make up for this loss (okay, we’re more in the league of a paper route startup, but small numbers are easier to understand). In the second year (Year 1 – 2), you clear $1,000 in profits. Your third year (Year 2 -3) picks up and you rake in $3,000. In your fourth year (Year 3 – 4), the heavens open and you pile up $9,000 in profits. In your fifth year (Year 4 – 5), all hell breaks lose and your paper route hoovers up $45,000 in revenues.

We’ve already taught you how to calculate the return on this investment with a net present value, internal rate of return, or modified internal rate of return.

But when do you “get your money back”?

If you were paying attention in third grade and you know how to add, you can arrive at this information pretty quickly. Your initial investment is -$10,000. Your first year loss is -$1,000. Total: -$11,000 at the end of the first year. In the second year you make $1,000. Total return: -$10,000 at the end of the year. Third year, another $2,000 shows up. Total return: -$8,000. You’re still in the hole after three years. However, in the fourth year, you make $9,000. Total return: $1,000 at the end of the year.

That’s simple, but not very precise. When in the months between Year 3 and Year 4 does your investment pay off? Unless you’re projecting monthly cash flows, this is going to require a bit of seventh grade math and some pretty unfounded assumptions.

If you were to assume constant cash flows through each year – that is, the $9,000 you make in the fourth year arrives in even, monthly increments throughout the year – you would divide $8,000 (your total return by the end of the fourth year) by $9,000 (your revenues for the fourth year) to find the fraction of the year it took to bring the total return to 0, that is, the fraction of the year it took to make $8,000, which turns out to be 0.88. You have now successfully calculated that your investment will pay off in 3.88 years, or 3 years and 11 months.

So, according to your financials, sometime in your fourth year your investment turned positive. The time to that transition — from a negative investment (loss) to a positive investment (return on your investment) — is the “payback period” or “payback” for short.

Why payback matters
So why should you care? And, more importantly, why should a prospective investor care? Especially since your prospective financials are all fancy and fantasy?

The payback period says volumes about the liquidity and security of the investment. A long payback period not only means that capital will be tied up (and hence illiquid and not available for other uses), it also means that the investment is at greater risk to the slings and arrows of time, business cycles, and the fickle marketplace. A (convincing) short payback period means that capital will become available for other investments and that the investment will be secure after only a short period – after an investment has paid off, the only losses are on future gains, not on the original investment.. After all, once the investment has been “paid back,” you can only lose money if you make a further investment in the business or project.

So determining payback tells you – and prospective investors – vital security and liquidity information about your investment that net present value and IRR’s do not. Don’t – as they say in another context – leave home without it.

Tomorrow: Calculating payback in your spreadsheet

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