The payback ratio is a way that you can determine how long it will take a company to recuperate its initial capital outlay on an asset. So, the ratio tells you how long it will take a company to earn back the money it invests in an asset. This is a useful tool for businesses because it allows the business to compare two different assets with two different cash outflows to see which yields a return first.
List the estimated cash in flows and out flows for your purchase for each year you plan to use the asset. For example, assume you want to use an asset five years. Year one you have cash inflows of $100 and outflows of $1,000, year two you have inflows of $300 and outflows of $500, year three you have inflows of $1,000 and outflows of $0, year four and five are the same as year three.
Subtract the cash out flows from cash in flows to find net cash flows for each year. In the example, the net cash flows are minus $900, minus $200, $1,000, $1,000 and $1,000.
Find the absolute value of the net cash flow from the last year with negative cash flows, then divide the amount by net cash flow the previous year. Absolute value means, you take a negative number and make it positive. In the example, $200 divided by $1,000 equals 0.2. This is the time during the year, you will have the positive total net cash flows.
Add the year number which had the last negative cash flows to the decimal from the previous step to calculate payback ratio. In the example, two plus 0.2 equals a payback ratio of 2.2.