Money Metrics: Payback Periods
It’s Payback Time
Yesterday we covered Break-even Analysis, which is one way to understand how much you need to sell for your business to be profitable. Sometimes it is more useful to know when a specific investment will become profitable, and that’s done using a Payback Analysis.
Payback, which is very well-named, refers to when an investment you have made returns the amount you paid for it (break-even). For example, if your Customer Acquisition Cost is $200 and you charge customers $20 per month, it will take 10 months for each customer to payback their cost of acquisition. That 10 months is known as the Payback Period.
That is really simple.
I agree! However, often it’s not very useful to think about every investment individually when considering the payback period. The real question is how the payback period affects your business! The key is to think about the payback period as if it’s a loan you made that you need to wait to be paid back. At first you might make a lot of loans, which means you spend a lot of money, but eventually they will start paying back with interest!
The payback period is an important part of understanding your capital needs. How much capital do you need to invest before you start to see it payback and generate positive cash flow? Going back to our example from above, if you acquire 100 customers a month then you will spend $2,000 per month which you will not get back for 10 months (payback period)!
Even after the first 10 months are up, you will still be net negative on your working capital as you’ve been spending on more customer acquisition during those 10 months. So the time it takes you to being to get to positive cash flow on your payback investment may be much longer.
Your capital balance will look like the following:
Note that are more net negative after Month 3 than Month 1 because you’ve spent a lot of money in those three months that you haven’t yet had paid back. Even after your payback period (month 10) you are still negative because only the first month has paid back! It’s not until Month 19 that enough of your monthly investments have paid back do you become net positive.
Understanding how your payback period affects your total capital requirements is critical to making sure you don’t go out of business before you start to generate more cash than you are spending! Often, companies fail during the period of net negative cash flow due to mistaken calculations and a lack of capital.
The great news, is that once your investment starts to payback the compounding can accelerate quickly. This is true of paying to acquire customers, hiring more staff or investing in new products. So don’t fear the payback period, just make sure you understand it very well.
Quote of the Day: “If you want to pay me back one day, that’s up to you. I’m not asking for it, and I never will. The best way you can pay me back is by becoming the person you want to be.” ― C.R. Strahan, Lucid Dreaming