Profitability index: concept, formula

2024 Author: Henry Conors | [email protected]. Last modified: 2024-02-12 02:46

The profitability index shows how profitable a particular project will be (relatively), or how much money will be received in the course of this project. In this case, only one investment unit is taken into account.

Investment and profitability index

Before investing your money in a particular project, you need to try to determine which option will bring the most profit and how good the benefit you get. It is in order to find out this information that there is a so-called investment profitability index. This indicator is also called the profitability index, or PI.

What you need to know about the investment profitability index

With its help, you can easily calculate the relationship between current income and current expenses. At the same time, the funds that were invested in the project are also taken into account. In addition, the calculation can be both real (in this case, the funds that were received over the past period of time are calculated) and predictive (when those incomes and expenses that are taken into account are taken into account).will still take place).

If after calculations it turned out that PI is less than 1, then it can be argued that you received a net profit from investing in the project, which is less than the funds that were invested in it. This gives the right to claim that such an investment of money was unprofitable.

If the investment profitability index is equal to 1, then the project may or may not be profitable. But a PI that is greater than one means that you have invested your money wisely and will receive a fairly large income. At the same time, it is worth remembering that the larger the value obtained, the more stable and reliable the project is considered. Also remember that when calculating long-term projects, it often happens that the initial profit may not be more than capital, so consider the time period.

Advantages and disadvantages of the index

The profitability index has its pros and cons. Among the advantages of this method, the most important is that it allows you to ideally distribute funds over time. In addition, it can be used to determine what effects a particular project had during its entire existence, as well as compare projects of different scales.

But it also has its drawbacks. For example, the profitability index makes it difficult to rank projects that have different durations without problems. But, despite all the disadvantages, it is with the help of PI that you can easily evaluate the effectiveness of sufficiently long-term investments and be able to calculate the profit.

Profitability index formula

If we talk about how to calculate PI correctly, then here you need a special formula that looks like this:

PI=PV_in / PV_out

or so

PI=1 + NPV / PV_out

In these formulas, PV_in (NPV) is the net present value of the project and PV_{out is the capital investment.}

The profitability index, the formula of which was described above, does not mean that you will definitely receive the absolute amount of net cash flow, because it only indicates the ratio to investment costs.

If you are an investor and want to determine how successful this or that project will be, then you need to know that the greater the investment costs, the greater the amount of net cash flow that you plan to receive. Also, the amount will be affected by the so-called volume of investment costs for different time periods. Has an important impact on the amount of cash flow and when the operational phase began. The discount rate has a significant impact on the cost of the main indicators of the project in the field of investment.