Examining Liquidity and an Investment's Payback Period
For many smaller businesses, liquidity is important. You can make only a limited number of investments. Additionally, you have a limited amount of capital — less than you like, almost always. New opportunities and ways to invest your money continually arrive. For these reasons, you typically want to look at the liquidity of your capital investments.
One easy way to measure liquidity is with a payback period, which measures what it takes for an investment to pay back its original investment. You do that with this formula:
initial investment/annual cash flow = payback period
Suppose that you're considering a $10,000 investment that produces $2,000 a year in net cash flows. In this case, you can calculate the payback period with the following formula:
$10,000/$2,000 = 5
This means that the $10,000 investment, through its $2,000-per-year cash flows, takes five years to pay back.
Again, you don't want to focus on liquidity. Liquidity is almost never as important as profitability. But even though profitability is paramount, liquidity is often something that you want to consider. At times, you're going to want investments that pay back more quickly rather than those that pay back less quickly. When the investments do pay off, you'll have other good reinvestment opportunities.