Profitability Index Formula Explained With Examples Finance Courses, Investing Courses

The profitability index is calculated by dividing the present value of future cash flows that will be generated by the project by the initial cost of the project. A profitability index of 1 indicates that the project will break even. Where “PV of future cash flows” is the present value of cash flows, starting from period 1 until the end of the project, and NPV denotes the Net Present Value.

It’s crucial to consider that the profitability index’s calculation involves an analysis of the project’s cash flows against the cost of capital, also known as the discount rate. This shows how much a business is earning, taking into account the needed costs to produce its goods and services. Internal rate of return (IRR) is also used to determine if a new project or initiative should be undertaken. Broken down further, the net present value discounts after-tax cash flows of a potential project by the weighted average cost of capital (WACC). Return ratios provide information that can be used to evaluate how well a company generates returns and creates wealth for its shareholders. These profitability ratios compare investments in assets or equity to net income.

  1. More specifically, the PI ratio compares the present value (PV) of future cash flows received from a project to the initial cash outflow (investment) to fund the project.
  2. The higher the profitability index, the more attractive the investment.
  3. The profitability index is calculated by dividing the present value of future cash flows by the initial cost (or initial investment) of the project.
  4. A Profitability Index greater than 1 indicates a potentially profitable investment, while a value less than 1 suggests a potential loss or lower return.
  5. This step involves applying a discount rate – usually the cost of capital attributed to the project – to every future cash inflow.

The profitability index can also get referred to as a profit investment ratio (PIR) or a value investment ratio (VIR). It represents the relationship that exists between the costs and the benefits of a potential project. The profitability index is the ratio between the initial amount invested in a project and the present value of future cash flows. Profitability index (PI) is the ratio of present value of a project’s expected future cash flow and initial investment needed to undertake the project. It helps companies and investors measure the expected return for each dollar invested into a project or venture.

It can be very helpful in ranking potential projects in order to let investors quantify their value. In the screenshot below, you can see how many of the profitability ratios listed above (such as EBIT, NOPAT, and Cash Flow) are all factors of a DCF analysis. The goal of a financial analyst is to incorporate as much information and detail about the company as reasonably possible into the Excel model. Return on invested capital (ROIC) is a measure of return generated by all providers of capital, including both bondholders and shareholders. It is similar to the ROE ratio, but more all-encompassing in its scope since it includes returns generated from capital supplied by bondholders. There are various profitability ratios that are used by companies to provide useful insights into the financial well-being and performance of the business.

How Is Business Profitability Best Measured?

The ROA ratio specifically reveals how much after-tax profit a company generates for every one dollar of assets it holds. The lower the profit per dollar of assets, the more asset-intensive a company is considered to be. Highly asset-intensive companies require big investments to purchase machinery and equipment in order to generate income. Examples of industries that are typically very asset-intensive include telecommunications services, car manufacturers, and railroads.

Investors can use them, along with other research, to determine whether or not a company might be a good investment. The profitability index is also called the profit investment ratio (PIR), cost-benefit ratio, or the value investment ratio (VIR). The profitability index (PI) is used to assess how much profit may come from a particular investment. Although not that common among finance professionals, as opposed to NPV and IRR, it is still considered economically sound. Governments and NGOs normally use this index when performing capital analysis.

Examples are gross profit margin, operating profit margin, net profit margin, cash flow margin, EBIT, EBITDA, EBITDAR, NOPAT, operating expense ratio, and overhead ratio. The profitability ratios often considered most important for a business are gross margin, operating margin, and net profit margin. ROE is a key ratio for shareholders as it measures a company’s ability to earn a return on its equity investments. ROE, calculated as net income divided by shareholders’ equity, may increase without additional equity investments. The ratio can rise due to higher net income being generated from a larger asset base funded with debt. It’s analyzed in comparison to assets to see how effective a company is at deploying assets to generate sales and profits.

This return ratio reflects how well a company puts its capital from all sources (including bondholders and shareholders) to work to generate a return for those investors. It’s considered a more advanced metric than ROE because it involves more than just shareholder equity. The more assets that a company has amassed, the greater the sales and potential profits the company may generate. As economies of scale help lower costs and improve margins, returns may grow at a faster rate than assets, ultimately increasing ROA. Cash flow margin is a significant ratio for companies because cash is used to buy assets and pay expenses.

Return on Assets (ROA)

Archer requires an investment of $300,000 and Brochure requires $200,000. If we think about Brochure, for instance, the 18 cents means that for every $1 we invest in brochure, we expect to earn 18 cents. Like we said at the start of this article, it’s helpful to know how to calculate the NPV, and we’re going to assume that you’re fairly comfortable with that. Because the NPV / I approach shows us exactly how much money we make for every pound we invest. Well, it just means that for every £1 pound you invest in Project A, you earn 50p. This shows you how much money you make for every one dollar or one pound you invest.

These additional capital outlays may factor in benefits relating to taxation or depreciation. Assuming that the cash flow calculated does not include the investment made in the project, a profitability index of 1 indicates break-even. Any value lower than one would indicate that the project’s present value (PV) is less than the initial investment. As the value of the profitability index increases, so does the financial attractiveness of the proposed project.

What is Profitability Index?

These include net income from operations, operating margin, and corporate taxes. It offers a comparative analysis of a project’s profitability by relating the present value of future cash inflows to the original investment expense, thereby aiding in resource optimization. Also, PI is based on estimated cash flows and discount rates, which could be inaccurate or subject to changes. Moreover, PI might not be the best tool for mutually exclusive projects with different sizes and timing of cash flows.

The numerator is the present value of cash flow that occurs after the initial funds have been invested into the project. The denominator consists of the total funds the firm initially needs to undertake the opportunity. A company uses this calculation to determine if it’s worth introducing the product. They usually use this calculation before or after the production stage. For example, the profitability index can be used to determine if a new product or service should be introduced into the market.

What Can Profitability Ratios Tell You?

The best uses of the profitability index involve investments in new products or services. It also helps to avoid spending on something that won’t be profitable. For example, taxes must be considered when determining a profitability index.

The Profitability Index, also known as the Profit Investment Ratio, is a financial metric that enables businesses to assess the potential profitability of an investment. By considering both the timing and magnitude of cash flows, the PI gives a holistic view of the investment’s profitability. While profitability ratios are a great place to start when performing financial analysis, their main shortcoming is that none of them take the whole picture into account. Return on equity (ROE) – expresses the percentage of net income relative to stockholders’ equity, or the rate of return on the money that equity investors have put into the business. The ROE ratio is one that is particularly watched by stock analysts and investors. A favorably high ROE ratio is often cited as a reason to purchase a company’s stock.

How to Calculate Profitability Index

The PI’s main advantage lies in its ability to help businesses prioritize projects, especially when resources are scarce. A PI more significant than 1 (like in this example) suggests the project is a good investment. A PI of less than 1 indicates the project may not be worth investing in. The NPV method reveals exactly how profitable a project will be in comparison to alternatives. When a project has a positive net present value, it should be accepted. When weighing several positive NPV options, the ones with the higher discounted values should be accepted.

Examples of less asset-intensive companies are advertising agencies and software companies. Therefore, the formula divides the present value (PV) of the project’s future cash flows by the initial investment. This computation yields a prospective freelance accountant ratio that becomes a beneficial tool in the decision-making process. A PI exceeding 1 signifies that the present value of future cash inflows overruns the initial investment, suggesting that the project may be a lucrative venture.

If the expenses outweigh the potential revenue, then it’s not worth it. The company would then decide to either lower the initial cost of production or scrap the idea altogether. Examples include capital expenditures, operating costs, taxes and interest, and more.