Whenever you think of investing your money in a project, needless to say, you would want to get your profit back. However, most of the time, many project investments are based on mere guesswork.
Whether you are going to gain profits out of a project is regarded as a matter of intuition by several people. Since it is highly important that you evaluate the chances of profitability before investing in a project, you get a significant calculation to back you up. But what if you get a metric that helps you evaluate this specific aspect?
That is where Profitability Index comes into the picture. It provides an easily understandable ratio that can assist you in making various decisions. In this post, let’s talk about the definition of profitability index, its formulas and calculation.
What is the Profitability Index?
Also known as the Profit Investment Ratio (PIR) or Value Investment Ratio (VIR), the Profitability Index (PI) helps represent the relation between the advantages and costs of a potential project.
This one is a simple ratio that designates whether an investment project will be profitable or not by showcasing the value created by every investment unit.
It is evaluated as the ratio between the initial amount invested in the project and the present value of future anticipated cash flows. The higher the PI, the more attractive will be the project.
Importance of Profitability Index
Companies generally use the profitability index as it lets them see the amount of money they may make. In simple words, it can assist in avoiding the selection of the wrong project. This could be from a decision over a specific period or concerning their investments. This also helps managers decide whether an investment will be a good one.
Apart from this, when it comes to comparing the performance of varying businesses, the profitability index lends a helping hand.
Suppose you have two organizations with the same operations and assets. The profitability index will help you figure out which company is making more and better profits. This may showcase that one organization has a more operative management structure than the other. Furthermore, this may also mean that one organization’s customers are ready to pay more than the other organization’s customers.
Formula of PI
The profitability index formula indicates the present value of future cash flows, which is divided by the initial project cost. Mathematically, it is presented in the following manner:
Profitability Index = Present Value of Future Cash Flows / Initial Investment
Moreover, there is one more representation of the PI formula, which is:
Profitability Index = (Net Present Value + Initial Investment) / Initial Investment
After putting numbers into the profitability index, you can determine whether to move forward with a project.
Let’s elaborate it further with an example. Suppose you are considering investing in a project that will cost you Rs.1000 in initial investment. The expected returns from this project will be Rs.1300. By putting these numbers into the equation, here is what you get:
Profitability Index = 1300 / 1000
Thus,
PI = 1.3
Since the value of PI is bigger than one, the project is going to be profitable for you.
Components of PI
There are two significant components of PI, such as:
- The Numerator (Present Value of Future Cash Flows)
The PV of future cash flows need the application of time value of money calculations.
The correct number of periods is used to discount cash flows to compare future cash flows to current monetary levels.
Discounting accounts come from the notion that the value of $1 today will not be the same as the value of $1 in the next year as current money has more earning potential as compared to the money that is hitherto unobtainable.
Thus, cash flows received in the future are regarded to have a lower present value than money received in the present.
- The Denominator (Investment Required)
The discounted predictable cash outflows showcase the initial capital outlay of a specific project. The required initial investment is the cash flow needed at the beginning of the project. All the other outlays might occur at any point in the project’s life.
Also, all of this is factored into the calculation via the discounting use in the numerator. Such extra capital outlays might factor in advantages pertaining to depreciation or taxation.
Interpreting the Profitability Index
As mentioned above, the higher the PI, the more striking the project will be. So, for example, if the value of PI is more than one, the project will be regarded as a good investment. If the PI is equal to one, the project represents a break-even point, and the company will be indifferent between moving forward and not proceeding with that project.
Usually, these values are positive and not negative. However, one disadvantage of PI is that the technique doesn’t consider the project size. For example, even if a project has significant cash inflows, it can still result in lower PI calculations since the profit margins may not be high.
Also, if the calculation is less than one, it simply says that the deficit of outflows is more than the discounted inflows. In such a situation, the project should not get accepted.
Conclusion
Irrespective of the business type you are operating or the industry you are working in, generating a profit is essential to expand or grow. As far as possible investments and projects are concerned, you must comprehend the benefits you can receive before making any decision.
With a profitability index, you can easily determine the benefits and costs of a potential investment or project. Once you know the PI value, you can then decide on what will be best for your business in the future. Keep in mind that the outcome can be an increase in possible profitability or a higher return on investment.
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