An Entrepreneur’s Guide to Profitability Index
Ezra Cabrera | September 11, 2021
As a business owner, you want to avoid the risk of investing your money into a project that won’t ultimately contribute to your company’s bottom line. A profitability index is a helpful tool for evaluating the potential profitability of investments.
Let’s say you had three separate marketing projects in the works, but your budget only allows for one to be properly executed at the present time. Calculating the profitability index for each, based on your initial investment, would be an effective way to determine which project to move forward with. Profitability index ratios are the metrics that business owners use to measure the value of an investment and to rank projects based on their profitability.
What is the Profitability Index?
Otherwise known as value investment ratio (VIR) or profit investment ratio (PIR), the term profitability ratio (PI) refers to a business metric that measures the degree of financial gain on a specific investment or project – whether it’s a marketing strategy, product expansion, or other business growth initiatives. By calculating the profitability index, a business owner can determine the value for each unit of investment and whether or not it will lead to a good financial outlook in the future.
The profitability index helps entrepreneurs navigate decision making with regards to what projects they should fund based on the project’s anticipated return of investment (ROI). It essentially lets entrepreneurs rank different planned projects to determine those that are most worthy of funding.
How Do You Calculate the Profitability Index?
Ideally, a business project should have a profitability index greater than 1.0 to be considered a profitable investment. A profitability index of 1.0 is the breakeven point, so anything less than that would indicate a loss of profit for a company. The higher a product or project’s profitability index is, the better investment it is for the company.
Here is the formula for calculating a project’s profitability index:
Profitability Index = Present Value (PV) of Future Cash Flow from Projects / Initial Investment Required
Let’s break that down. The future cash flow is the amount of money that the company expects to earn in the future for that specific investment. The present value is the discounted value of the expected cash flow as a result of the investment in the future. This works on the time value of money accounting principle, which states that money you have available at present day is worth more than what that same amount will be in the future, due to its potential earning capacity.
Here is the formula for calculating the present value (PV):
Present Value (PV) = FV / (1+i)^n
Where,
FV = anticipated Future Value
i = anticipated interest rates in letting the amount of money sit idly
n = expected number of years before seeing an ROI
The initial investment is simply the sum of money required to fund the project. This is the cash used at the start of the project. If the potential earnings are lesser than the amount you invested initially, it won’t make sense to invest in that particular project.
When calculating the project’s profitability index using the profitability index formula, it’s worth noting that the calculation doesn’t consider the size of the investment. With that said, you can expect to come up with a lower result when calculating a project size with a larger cash outflow. This is because the investment’s profit margin isn’t as high as the initial investment.
What the Results Mean
When using the profitability index formula, managers can come up with a number less than, equal to, or greater than the value of 1. Here’s what each of the results means:
A PI Less than 1
A PI less than 1 translates to a loss of investment should the company move forward with the investment. Projects with a PI under 1 are not advisable for investment.
A PI Equal to 1
A PI calculation of 1 is the breakeven point. This means the proposed project could potentially lead to profit for your company, but it may not. Companies should only consider going with projects with PI equal to 1 when they’re comparing the said investment to others with a PI of less than 1.
A PI Greater than 1
If the profitability index formula produces a PI greater than 1, it indicates that a proposed project is profitable and worth investing in.
The higher the PI, the more profitable an investment is projected to be. If a company is choosing between multiple projects with a PI above 1, it should select the project with the highest calculation. Especially if the company has a limited budget, this method is particularly effective for making smarter financial decisions with limited resources.
It should be noted that in situations where the company is experiencing capital constraints or mutually exclusive projects, only proposed investments with the highest PI should be considered.
Profitability Index Ratio
The profitability index ratio reflects the expected future return on a particular investment. For instance, a profitability index of 0.5 means you’ll have a ratio of $0.50 for every dollar of money you put into your investment. In this instance, you wouldn’t be able to profit from that particular project. On the other hand, if you have a profitability index of 1.3, that translates to $1.30 per unit of investment, which would yield a profit.
Profitability Index Advantages
The profitability index is one of the numerous types of metrics companies can use to determine a project’s potential for improving the company’s bottom line. Other techniques, such as the Net Present Value (NPV), are also widely used.
Companies typically use the PI method when choosing which projects to fund for the following four reasons:
1. It’s Easy to Understand
The formula for the profitability ratio index is a straightforward division problem, making it easy for business owners to apply and utilize.
2. It Considers all the Cash Flow in the Project
When using the profitability index to determine a project’s profitability, the method itself takes into account all the cash inflows and outflows involved in the project – even those that aren’t classified on the books. The calculation also allows businesses to consider the value created per unit of investment, thus giving the company a better insight into the profitability of a specific project.
3. Profitability Index Takes the Time Value of Money into Account
When calculating the present value – as part of the larger PI calculation – you have to evaluate how the value of your investment will change in the future by applying the time value of money principle. As a result, the profitability index gives you more accurate information about your investment’s return rate in the future.
4. Shows Whether a Particular Investment Will Increase the Firm’s Value or Not
The results you get from calculating your project’s profitability index will help you get an idea of how a particular project will contribute to the company’s success. For instance, if project X’s profitability is less than 1, the managers should turn the project down and go for another plan – one with a PI greater than 1 – that can potentially improve the company’s bottom line (because of the greater return on investment).
Profitability Index Disadvantages
There are also downsides to using profitability indexes to know a certain investment’s profitability. Here are three disadvantages of PI:
1. Possibility of Incorrect Assumptions
Since you’re estimating your future cash flows based on assumptions, this does leave room for inaccuracy. The profitability index formula requires an estimate of the cost of capital, so it can generate the project’s PI. That said, if a company is deciding between mutually exclusive projects, the PI won’t be a reliable basis for decisions.
The business world is volatile and economic trends could change at any time which would lead to unforeseen changes to your assumption. A project you’re considering investing in that projects to be profitable today, may not actually be in the future. Unexpected changes could render profitability index calculations useless.
2. It Doesn’t Consider Opportunity Costs
When you have a number of projects you are considering for investment, but only have the budget to invest in one, your opportunity cost is defined as the loss associated with those projects you don’t end up moving forward with. Say you have three projects lined up, all with a PI greater than 1, but you can only choose the one with the highest PI. You are giving up the potential profit earned by the other two you don’t select.
3. Overestimation of the Figures
Business owners or teams can overestimate the figures used in calculating a specific investment’s profitability index with the use of the profitability index formula. This is especially true in cases where they are optimistic and overconfident about the project’s success. They could use optimistic numbers in the calculation creating a bias and, possibly, an error in their final estimates.
Profitability Index: Final Thoughts
Profitability index calculations are a helpful tool in determining the level of profitability of particular investments. However, businesses should also be aware of the advantages and disadvantages of using this method. Keep in mind that changes in the business cycle could affect your estimated values. It’s also helpful to control the bias on each project. Stick to realistic values when making estimates. When calculating your profitability index, it would be beneficial to do try different numbers on the profitability index formula, so you can make the most informed decision as to which projects would lead to the most gains for your company.
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