If you want to know whether your business is actually generating profits or what is your profitability
as compared to other competitors? Then you might be willing to calculate your profitability index.
What Is The Profitability Index?
Profitability index definition illustrates the relationship between the future cash flows of the company and the company’s initial investment, and this is shown by manipulating the ratio and evaluating the project feasibility. It is also known by the name profit investment ratio as it is calculated by adding one and dividing the present value of the company’s cash flows by initial investment.
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The main usage of this tool is to rank down the investment projects as well as to show the value which is formed for each unit of the investment. Some of the other names for Profitability index are the Profit Investment Ratio (PIR) and the Value Investment Ratio (VIR).
Therefore, you need to calculate the rate of profitability to know the return and the desirable profit from the business.
What Is The Formula For Profitability Index?
1. Simple Calculation
The formula used or simply applied while calculating profitability index is as:
Profitability Index = Revenues / Profits
2. Detailed Calculation
In the detailed calculation, we apply 2 lengthy formulas to calculate profitability index, which are as:
- Profitability Index Formula # 1
Profitability Index = Present Value of the Future Cash Flows / Initial Investment Required
For, this you just need the present value of the forthcoming cash flows as well as the opening investment of the venture concerned.
- Profitability Index Formula # 2
Profitability Index = 1 + (Net of the Present Value / Opening Investment Required)
Though, the profitability index formulas depicted above will yield the same result or output.
Interpretation Of PI Formula:
- If the index or output is more than 1, then we can say that the investment is worthy enough and you can surely earn more than what you have invest in the business. So, you can opt for investments having PI more than 1.
- If the index or output is less than 1, then you should look out for other available opportunities as the investment is not worthy enough. As, less than 1 PI, indicated the loss of the money invested in the business.
- If the index or output is equal to 1, then it is a neutral project to work on. Neither it is earning over and above your invested money, and nor it is turning out to be unprofitable for you. So, while having a PI equal to one, you should evaluate and consider other projects as well and then make the appropriate decision.
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What Is Good Profitability Index?
So, here after considering the PI. A good PI is the one that will yield out a good return in the business and overall will prove to be worth the investments in the business. Therefore, a positive profitability index can be considered as a good profitability index, useful for a profitable and growth in a business.
Components Of Profitability Index
Components of Profitability Index that are used while calculating the Profitability Index are:
1. Present Value:
The present value depicts the existing value of the sum of money, as compared to the future sum of money.
Thus, Cash flows which are received or are to be received in future have a lower present value as compare to the one that is about to be received in present.
You can use the following Present value formula to calculate the PV:
PV = FV/ (1+i) ^n.
Here, in the above formula
- 1 = is considered as the “principal” amount
- i = is the interest and
- n = the number of years.
2. The Required Initial Investment:
It is the amount which you want to forego in order to earn more. Thus, the initial investment is the amount you have invested in the business for the profitability of the business.
3. Net Present Value:
Though, The NPV depicts the variance between the present or the existing value of cash inflow and the present or the existing value of cash outflow or the amount invested or capitalized and the amount gone out of the business. And, in order to be successful, the NPV ought to be positive for any investment, that will yield positive results for the business. And in case there is a negative profitability index, then we will not consider the investments as it will not bring about favorable results to us.
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How to Calculate the Profitability Index?
- Step 1: First of all, you need to calculate the initial investment of a project that is based on the requirement of the project as well as on the capital expenditure of the company involving machinery, equipment, and all other expenses that are considered as capital in nature.
- Step 2: Now, future cash flows are needed to be assessed. After which discounting factor is calculated which is based on the current expected return of the business. So, thus with the help of the discounting factor, we can know the present value of the future cash flows that is expected from the business.
- Step 3: Lastly, the profitability index be situated out by dividing the current or existing value of all the future value of cash flow with the project and the initial or the opening investment of the project.
Profitability Index Example:
A company KLO Ltd has decided to invest in a project having the yearly cash flows as follows:
- $2,000 in Year 1
- $7,000 in Year 2
- $6,000 in Year 3
Though the initial or the opening investment obligatory to maintain for the project was $10,000 and the discounting rate of the investment is 10{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39}. So, we will find out the Profitability Index by using the formula,
PV of the cash flow = FV/ (1+i) ^n.
- Calculation For Year 1:
PV of the cash flow (Year 1) = $2,000 / (1+10{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39})1 = $1818
- Calculation For Year 2:
PV of the cash flow (Year 2) = $7,000 / (1+10{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39})2 = $5,785
- Calculation For Year 3:
PV of the cash flow (Year 3) = $6,000 / (1+10{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39})3 = $4507
So, the Totality of the PV of future cash flows will be:
PV of cash flow (Year 1) + PV of cash flow (Year 2) + PV of cash flow (Year 3) = $1818 + $5,785 + $4507 = $12,110
Thus, the project Profitability Index will be = $12,110
/ $10,000 = 1.211
Ad, as the project’s Profitability Index is more than 1, then we can say that it is profitable to invest in the business.
How to Calculate the Profitability Index in Excel?
Now, we will consider the same example as above with the help of an excel sheet.
-
Calculation For Year 1:
PV of cash flow (Year 1) = $2,000 / (1+10{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39})1 = $1818
Representation in excel sheet as:
| S.N. | A | B |
| 1 | Annual Cash flow for year 1 | $2000 |
| 2 | Discounted Rate | 10{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} |
| 3 | Present Value of cash flow in 1st year | $1818 |
Though, the formula used in the excel sheet is =B1/(1+B1)^n
-
Calculation For Year 2:
PV of cash flow (Year 2) = $7,000 / (1+10{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39})2 = $5,785
Representation in excel sheet as:
| S.N. | A | B |
| 1 | Annual Cash flow for year 2 | $7000 |
| 2 | Discounted Rate | 10{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} |
| 3 | Present Value of cash flow in 2nd year | $5785 |
Calculation For Year 3:
PV of cash flow (Year 3) = $6,000 / (1+10{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39})3 = $4507
Representation of PV of the cash flow in the excel sheet as:
| S.N. | A | B |
| 1 | Annual Cash flow for year 3 | $6000 |
| 2 | Discounted Rate | 10{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} |
| 3 | Present Value of cash flow in 3rd year | $4507 |
Though, the formula used in the excel sheet is =B1/(1+B3)^n
So, the Sum of PV of the future cash flows in excel will be shown as:
| S.N. | A | B |
| 1 | PV of cash flow (Year 1) | $1818 |
| 2 | PV of cash flow (Year 2) | $5785 |
| 3 | PV of cash flow (Year 3) | $4507 |
| 4 | Sum of PV of cashflows | $12110 |
The formula used in the excel sheet = SUM(B1: B3)
So, Profitability Index of the project in the excel sheet will be:
| S.N. | A | B |
| 1 | PV of cash flow (Year 1) | $1818 |
| 2 | PV of cash flow (Year 2) | $5785 |
| 3 | PV of cash flow (Year 3) | $4507 |
| 4 | Sum of PV of cashflows | $12110 |
| 5 | Initial Investment | $10,000 |
| 6 | Profitability Index of the project | 1.211 |
| S.N. | A | B |
| 1 | Annual Cash flow for year 3 | $6000 |
| 2 | Discounted Rate | 10{367c01af22dc6c3a8611ff25983b0f0a247ed9fc1c45fd9103ad49b47a0c5f39} |
| 3 | Present Value of cash flow in 3rd year | $4507 |
The formula used to calculate Profitability index excel =B4/B5
So, by using the excel sheet the project Profitability Index is 1.211
What Is the Profitability Index (PI) Rule?
The rule of profitability index lets us know whether to opt for a business or whether to opt-out of business, by evaluating whether the project is profitable or worthy enough or not. And this is better understood, by knowing where the Profitability Index value lies. As
- The profitability index value is more than 1, then we can say that the investment is worthy enough and you can surely earn more than what you have invested in the business. So, you can opt for investments having PI more than 1.
- The profitability index value is less than 1, then you should look out for other available opportunities as the investment is not worthy enough. As, less than 1 PI, indicating the loss of money capitalized in the business.
- Profitability Index value is equal to 1, then it is a neutral project to work on. Neither it is earning over and above your invested money, and nor it is turning out to be unprofitable for you. So, while having a PI equal to one, you should gauge and consider other projects as well and then make the appropriate decision.
Advantages of profitability index
- The time value of money is considered while calculating the profitability index.
- All cash flows investigation is done in calculation of profitability index.
- the precise rate of return of the associated project is discovered with the help of PI.
- It assists to select whether to accept or to reject a particular project, depending upon the profitability index.
Limitations of Profitability Index
- The future cash flow estimations are not always accurate. Therefore, there exist some chances that the predictable future cash flows would turn out to be considerably different than what the actual outcome may be.
- Net Present Value Method (NPV) is considered as the best profitability index method to evaluate and to be considered when the PI of two projects are similar though the initial investment, as well as the return, are different.
- Profitability Index is based entirely on estimation rather than on facts and figures.
- Profitability Index does not provide a wise decision choice for a project.
- The sunk cost as well as the opportunity cost is ignored while calculating the Profitability Index.
- The discount rate linked with the project is tough to understand.
FAQ
What Does A Profitability Index Of .85 Mean?
A profitability index of . 85 for a project means that: the present value of benefits is 85% greater than the project’s costs.
Why Do We Calculate Profitability Index?
The profitability index rule is a decision-making exercise that helps evaluate whether to proceed with a project. The index itself is a calculation of the potential profit of the proposed project. The rule is that a profitability index or ratio greater than 1 indicates that the project should proceed.
How Do You Define Profitability?
Profitability is a measure of an organization’s profit relative to its expenses. Organizations that are more efficient will realize more profit as a percentage of its expenses than a less-efficient organization, which must spend more to generate the same profit.
What Is Profitability And How Is It Measured?
Profitability is the ratio between a business’s income and its expenses. A business determines its income by calculating the money the business generates through its operations and activities.
Conclusion:
Profitability Index helps us to know whether to invest in the business or not, thus acting as a worthy tool for finance. So, you can consider calculating PI for taking some decisions related to finance for your company. As, the higher the PI denotes the favorable the business option is, or the positive the Pi the higher it is to be considered.