Simple Payback vs. Discounted Payback
This calculator uses the simple payback method: divide the investment by the monthly cash flow and you know when you break even. It is straightforward and practical, which is why most small business owners use it.
The discounted payback method accounts for the time value of money. A dollar received today is worth more than a dollar received two years from now because you could invest that dollar elsewhere in the meantime. In the discounted method, future cash flows are reduced by a discount rate, typically 8-12% for small business investments, before being counted toward payback.
For most small business decisions, the simple method is sufficient. The discounted method matters more for large investments with very long payback periods where the difference between present and future value becomes significant. If your payback period is under two years, the difference between simple and discounted payback is usually a few months at most.
Why Shorter Is Better, but Not Always
Shorter payback periods are generally preferred because they reduce risk. The sooner you recover your capital, the sooner it is available for the next opportunity, and the less exposed you are to things going wrong.
But a strict preference for short payback can lead to underinvestment. A $5,000 tool with a 3-month payback might look better than a $100,000 truck with a 24-month payback, but the truck might generate $500,000 in value over its lifetime while the tool generates $20,000.
The right approach is to use payback period as a risk filter, not as the only criterion. Set a maximum acceptable payback period based on your cash position and risk tolerance, then evaluate everything that passes the filter on total lifetime value.
For most small businesses, these are reasonable maximum payback thresholds:
- Under 12 months: Almost always a good investment if the returns are real. Low risk, fast capital recovery.
- 12-36 months: Reasonable for durable assets like equipment, vehicles, and facility improvements. Make sure you have the cash reserves to wait for the payback.
- Over 36 months: Requires strong conviction and a solid cash position. The longer you wait for payback, the more things can go wrong: equipment breaks, market shifts, a new competitor undercuts you.
Capital Allocation for Small Business
Every dollar in your business has an opportunity cost. The money sitting in a truck payment could be funding a marketing campaign. The cash tied up in inventory could be earning interest or paying down debt. Capital allocation is the art of deciding where each dollar works hardest.
Large corporations have entire departments dedicated to capital allocation. Small business owners do it by instinct, and that instinct is often wrong. The most common mistakes:
- Shiny object syndrome. Buying new equipment or software because it is exciting, not because the numbers justify it. Always run the payback calculation before you buy.
- Ignoring maintenance investments. A $2,000 repair that extends the life of a $40,000 machine by three years has an incredible payback period, but it does not feel like an investment.
- Underinvesting in people. Training, better tools for your crew, performance bonuses. These investments often have the shortest payback periods but are the last place owners look.
- Cash hoarding. Keeping too much cash in a savings account earning 1-4% when it could be deployed in the business at 30%+ returns. Cash reserves are important, typically three to six months of expenses, but anything beyond that is idle capital.
The discipline is simple: calculate the payback period for every significant expenditure. Compare them. Fund the ones with the shortest payback and highest lifetime value first. Review quarterly to see if the actual returns match your projections.
Putting It Into Practice
Here is a practical framework for using payback period in your business decisions:
- For any investment over $1,000, calculate the payback period before committing.
- Be conservative with cash flow estimates. Use the low end of what you realistically expect, not the best case scenario.
- Track actual results after the purchase. Compare real monthly cash flow to your projection at 3, 6, and 12 months.
- Build a simple spreadsheet of past investments and their actual payback periods. Over time, you will develop much better intuition for which investments pay off and which do not.
The businesses that grow consistently are not the ones that make the biggest bets. They are the ones that make disciplined investments with clear payback expectations and track whether reality matches the plan.
Sources
- U.S. Small Business Administration - Manage Your Finances — Financial management guidance for small business owners
- SCORE - Templates and Resources — Free financial planning tools, templates, and mentoring for small businesses