What does it mean by Profitability Index?
Profitability Index – PI is also known as Profit Invest Ratio (PIR) and even called Value Investment Ratio (VIR) is a tool that helps you determine what will be your profit in a specific investment or project. This tool helps you to see the potential of the specific investment as an appraisal technique, you can also use this formula for ranking the project’s financial benefits with other investments. Profitability Index formula helps the people who have invested money in specific business or project to put numbers and see the amount of value created per unit of investment.
Let us know about the formula –
The calculation is done by this simple method of dividing the present value of future cash flows by initial costs of the project (initial costs means the initial investment has done which means the cost that includes the cash flow that was required from the basis of the project r investment), whereas in future cash flow you need not calculate the initial investment.
The formula looks like this
PI / PIR / VIR (Profitability Index) = Present Value of Future Cash Flow / initial investment in project.
You have to discount the future cash flow to the current value and also you must implement the time value of money calculation to use the method of Present value of future cash flow. This discount we have to make because the value of 1$ today will not be the same in the future, henceforth the value that we will receive near to present is considered more than the value we will receive in further future.
Now if the profitability index value comes 1 then this means that it is a no-profit no-loss investment and if the result is less than 1.0 then it is suggested the investment should not be done as it has no potential of profit, now in case you get the profitability index formula of more then 1.0 then the investors should invest in this project or investment as it has the potential to give profit. For example, if the result of the profitability index calculation is 1.3 then the investor may expect that he will receive $1.30 for his every $1.00 he invested in for that project.
When and how to apply this formula?
The application of profitability index is done when you want to rank the particular firm’s or project’s to invest money in. it is natural that any investor would like to invest money in only those projects where there is a high potentiality of returns and profit. When there are many options for projects to choose before you have to invest then you need to apply this formula and rank the project from high return to low return of investments. Sometimes even if a project is offering a high net pressure value it can be passed on by predicting the profit using financial calculations. There is a problem with this profitability index formula, you are not able to consider the complete scope of the specific project. In this case, you can use the net present value method but then this may also raise other problems. Hence every investor’s first concern is the time that is required by a project to become fully profitable.
So remember always use the profitability index formula as a guideline with other formulas like net present value and some other forms of multifaceted analysis, it would help you get a better outcome.