Skip to 0 minutes and 4 seconds So we have seen that there are several sources of funding for growing a business. However, what is it that the investors, lenders, or crowd funders are looking for? Why do they choose a particular business to provide funding to? For them, it’s all about something called return. When someone invests in a business, they are looking to get something back. We call this a return on the investment. Return for a shareholder is what gain they make relative to the initial investment. This could be in the form of a payment to shareholders, a dividend, or an increase in the share price. And hence, the value of their investment in a business.
Skip to 0 minutes and 50 seconds Return for lenders is what gain they make relative to the amount loaned. This will be in the form of interest charged on loans. They will eventually get their initial loan repaid by the business as well. One way in which investors assess whether to invest money in a business is called payback. So the concept of payback is ultimately working out if you launch product, when actually will you start seeing the returns from that product? When actually are you going to get some payback from it? From a total perspective, that’s the job of the accountant to work out. When are the returns coming in? What are these returns related to? What actually is the reason behind all of these financial movements?
Skip to 1 minute and 31 seconds But over a longer period of time, when I look at the full accounts and the full P&L, that’s when I’ll start to realise, OK, we made this investment in year one. Now we’re starting to see some of the sales come back and the sales increase in year three, for example. So we definitely would look at that on a long-term basis. Clearly, the financial performance of the business will affect the payback and the overall return on the money provided by the funders. For example, Jenny sets up a business at the start of year one. She borrows money from her parents and put 60,000 pounds into the business. The business makes cash flows of 20,000 pounds a year.
Skip to 2 minutes and 11 seconds So Jenny’s payback period is three years. She can give money back to her parents at the end of each year. Any cash flows made after this date then would go to Jenny. However, we need to be careful. In practise, cash flows tend to be more erratic. So Jenny’s cash flows could be 40,000 pounds in year one, and 10,000 pounds in each of years two and three. Alternatively, they could be 5,000 pounds each in years one and two, and 50,000 pounds in year three. In each case, the payback period is three years. But which of the three alternative sets of cash flows do you think Jenny’s parents would prefer?
Skip to 2 minutes and 56 seconds I suspect that they would prefer to receive 40,000 pounds in year one, as they could then do whatever they wished with the money as early as possible. If prices are rising then that is another reason to recoup the cash flows as quickly as possible. This is because they can buy more with their cash the earlier they receive it. This illustrates a concept known as the time value of money, which suggests that we would always prefer 100 pounds today rather than 100 pounds in a year, and 100 pounds in a year more than 100 pounds in two years. The further ahead we look, the more uncertain the future.
Skip to 3 minutes and 37 seconds And so as investors, lenders, students, parents, or anyone who ever has to deal with cash, we hold this to be true.
Return on investment: payback
What is it that draws investors to a business? And how do they decide which companies to invest in?
As we have seen, there are multiple sources of funding available to grow a business. But what is it that investors, lenders or crowdfunders are all looking for?
As Alice explains in this video, anyone who puts money into a business usually wants a return on their investment. This can come in several different forms but ultimately means a gain in value for the investor relative to their initial investment.
This means that a key factor for investors to assess whether or not to put money into a business is how long it will take for them to recover their initial investment. In business, this is often called payback.
In the next step, an interactive exercise will give you an opportunity to practice applying some of the concepts that have been introduced over the last few videos.
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