First, what is cash flow>
Cash flow is defined as an increase or decrease in an amount of cash.
And what is cash?
Cash is defined as ‘cash held in hand’ and any deposits repayable on demand with banks and any other qualifying financial institution, less overdrafts from a bank and any qualifying institution, repayable on demand.
What then is the difference between break- even analysis and payback period on the basis of cash flow?
The term break-even analysis as commonly used, does not capture the true meaning of the interrelationships it explores. Break-even analysis is not only concerned with the level of activity which produces the break-even point (where neither profit nor loss is produced). It is more concerned with how costs and profits behave at other levels. This is why the alternative term. Cost-volume-profit (c-v-p) is often used.
Break-even analysis or c-v-p analysis is relied upon for short term planning and decision making. It uses principles of marginal costing to explore relationships that exist among costs, small changes in output levels, revenue and profit.
The application of break-even analysis depends on some basic assumptions. Some of them include;
There will be no uncertainty,
All costs can be accurately resolved into fixed and variable costs,
Fixed costs will remain constant and variable costs will vary proportionately with activity,
Volume is the only factor that affects costs and revenues
No stock level changes or that stocks are valued at marginal cost only and,
That break-even analysis relates to a single product or constant sales mix.
How can break-even (c-v-p) be analyzed by formula?
Break-even point (in units) = fixed costs/contribution per unit (contribution = selling price – marginal cost),
Break-even point ($ sales) = fixed costs/contribution per unit x sales price/unit.
What is payback?
Payback as an investment appraisal technique, is defined as the time required for the cash inflows from a capital investment project to equal the cash outflows.
Payback is a method used to reduce risks and uncertainties associated with a project. The usual decision rule is to accept the project with the shortest payback period.
In applying a payback time limit, either a project in addition to paying back within a certain time limit should show a positive net present value (NPV) from its net cash flows. Or a project is expected to pay back in discounted cash flows within a certain time period.
Payback is the most popular project appraisal technique because it is simple to calculate and understand. It other advantages include;
it favors quick return projects and thus, minimizes time related risks and,
Its objectivity (it uses project cash flows instead of accounting profits).
However, payback analysis is not a measure of the overall worth of a project.
