What it means
The idea is close to the payback period, with the emphasis firmly on cash rather than accounting profit. Depreciation is excluded because it moves no money, while tax paid and any additional working capital tied up by the project are included because they genuinely do.
It matters because time is risk. The further into the future a business has to wait for its money, the more chance there is that demand shifts, technology changes or a competitor arrives, so a shorter recovery period means less exposure to an uncertain world.
Calculation is straightforward when the cash inflows are even: divide the outlay by the annual net inflow. When inflows vary, which is more usual, the cumulative cash flow is tracked year by year and interpolated across the year in which the total first turns positive.
Many businesses set a hurdle, such as accepting only projects that recover their cash within three years, and use it as a first filter before more detailed appraisal. The measure is easy to explain to non financial managers, which is a large part of why it stays popular.
Its weakness is that it ignores everything after the recovery point and, in its simple form, ignores the time value of money. A discounted version, which converts each year's cash flow to present value before accumulating, addresses the second problem and always produces a longer period than the simple calculation.
In practice
Real-world examples.
Example
A laundrette operator compares two machine suppliers. The cheaper machine costs $60,000 and recovers its cost in 2.4 years, while the premium machine costs $95,000 and recovers in 3.1 years but lasts four years longer, so the owner also runs a full appraisal before deciding.
Example
A logistics firm fits telematics across its fleet for $210,000 and saves $105,000 a year in fuel and insurance. The two year cash recovery period clears the board's three year hurdle comfortably and the project is approved without further analysis.
Example
A dental practice installs a scanner costing $180,000 that generates $45,000 of net cash a year. The four year recovery period exceeds the practice's policy limit, so the partners lease the equipment instead and preserve their cash.
Think of it
“Cash recovery period is how long until you get your cash back-payback in cash terms.
Formula
Calculation
Cash recovery period = initial cash outlay / annual net cash inflow when inflows are even, or the point at which cumulative net cash inflows first equal the outlay when they vary
A bakery invests $840,000 in an automated production line. Net cash inflows after tax are forecast at $240,000 in year one, $300,000 in year two, $360,000 in year three and $360,000 in year four.
Cumulative cash is $240,000 after year one and $240,000 + $300,000 = $540,000 after year two, still short of the $840,000 outlay. The shortfall entering year three is $840,000 - $540,000 = $300,000, and year three generates $360,000.
The fraction of year three needed is $300,000 / $360,000 = 0.83, so the cash recovery period is 2.83 years, or roughly 2 years and 10 months. Everything the line earns after that point, including the remaining $60,000 of year three and the full $360,000 of year four, is return rather than recovery.Case study
Seen in the real world.
This is an illustrative and clearly fictional example. Pinegrove Farms, an invented soft fruit grower, was choosing between two capital projects with the same $600,000 price tag. A polytunnel extension promised $200,000 of net cash a year for five years, while a new grading and packing line promised $120,000 a year for twelve years.
On total cash generated the packing line looked far better at $1,440,000 against $1,000,000. On cash recovery period the picture reversed: the tunnels recovered the outlay in $600,000 / $200,000 = 3 years, while the line took $600,000 / $120,000 = 5 years.
The fictional directors chose the tunnels, not because the arithmetic said the total return was higher but because their bank facility was up for renewal in four years. The illustrative point is that recovery period answers a question about risk and timing that a total return figure cannot.
Watch out
Common mistakes.
- Using accounting profit rather than net cash inflow, which understates the yearly figure because depreciation has been deducted even though no money left the business.
- Choosing between projects on recovery period alone, which favours quick, small projects and can reject a slower investment that creates far more value over its life.
- Forgetting the extra working capital a project absorbs, since more stock and more customer credit are part of the outlay that has to be recovered.
Questions
People also ask.
Is this the same as the payback period?
Effectively yes, with the cash label emphasising that the calculation should use cash flows rather than profit figures.
Should the calculation be discounted?
For anything beyond about three years it is worth running a discounted version, which converts each year's cash to present value and always gives a longer, more honest answer.
What counts as a good recovery period?
It depends entirely on the asset life and the sector, though many businesses look for recovery well inside half the useful life of the asset being bought.
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