The Payback Accounting Formula

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Payback accounting is all about evaluating the payback period, because it is a best practice. The most common definition of the payback period is that it is the period of time required for the repayment of the amount that was invested in an asset. The amount is repaid from the net cash outflow, and this is the amount from the initial or capital investment. The payback period is expressed in years to assist in best practices with all kinds of businesses.

Let us assume that a company invests $600,000 in a new project. The project produces $100,000 every year as cash flow through best practices. This means that the payback period is six years. The formula used is:

Payback Period =             First Investment =             $600,000 =             6 years

Annual Payback                                                $100,000

Advantages and Disadvantages of Payback Period

The advantages of calculating the payback period are all about risk assessment and risk management best practices. This provides a quick idea about the period of time the initial investment will risk ensuring compliance with best practices. Most business people tend to evaluate the risk involved with any investment based on the payback period. They hold on to the best practices of not investing in those assets that have longer payback periods.

However, this is more useful for those businesses where investments turn obsolete too soon. Similarly, payback accounting works best for those businesses where the return of the initial or capital investment is a major problem.

By using the payback accounting formula, one succeeds in best practices. It assists business people estimate the payback period, but there are some setbacks.

  • Life Span of the Asset: The formula does not give any idea about the life span of the asset in which the money invested. If the purchased asset expires after the payback period, there will be no additional generation of cash flow. This is bad for best practices.
  • Complexity of Cash Flow: Cash flow is complex and has multiple aspects related with the various cash flows in any business. In addition, cash flow in most businesses changes over a short and sometimes long period of time. This formula is too simple to account for the multitude of cash flows arising along the line. Therefore, it is not a recommended best practice.
  • Tracking Profitability: Payback accounting focuses on the time the payback will take, and not on the ultimate profit of the project. The payback accounting formula cannot determine the expected profitability over the period of time. This does not help with compliance best practices.
  • “Time Value of Money” Factor: The payback accounting formula does not consider the time value of money factor. Therefore best practices are not implemented effectively.
  • Wrong Averaging: The formula uses the average cash flow over the specific period of time in the denominator. However, if the forecast of the average cash flow is expected to be farther, the estimated average figure can be a wrong figure. This means the formula is not always accurate for average annual paybacks over longer periods of time. This can affect best practices negatively.

Nonetheless, using the payback accounting formula is an ideal best practice for both small and large business. It also helps with capital budgeting to promote best practices.

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