Profitability Index Explained

Knowing the profitability index rule is very important to know which investment opportunity should be grabbed and which one should be left. In this article, with the help of a formula, let us try and understand this concept in detail.
Investments are made to earn money in the future. We plan and execute them effectively, with a hope that we will be getting bumper returns in the future. However, most of the time, our plans are as per current market conditions and demand statistics. No one knows what will happen in the future and so determining how much yield the investments will give in the time to come is surely a challenging job. The profitability index can help gauge the degree of expected profits that we can earn from an investment.

How to Calculate Profitability Index?

As mentioned above, the profitably index can be calculated by knowing the amount to be invested. So, you need to first decide how much you will be investing for getting the desired returns in the future. Then the next step involves calculating the net present value of the income from the investment.

The net present value (NPV) is nothing but the current price of the future cash flow that is to be generated after a few years. All the cash flows cannot be earned in a single year. Our aim would be to achieve some amount in a particular year and then some more in the years to come.

So, in our calculation of net present value, we will have to determine the current value of the cash flow of all the years and then add it up. This simple addition will be giving us the total net present value of our investment.

Now, according to finance experts, this total net present value should be in excess of the amount which is being invested. If this is the case, then we can go ahead with the investment as it can be certainly very profitable.

On the other hand, if the total of the net present values of all years is less than the amount to be invested, then the investment would not be profitable and hence, we should think of some alternative investment options to meet our profit targets.

If the value of the profitability index is greater than one, then the project is generally accepted by the senior company management. In case it is found to be less than one, then they will have to think of other investment opportunities.

Profitability Index = Present value of cash flows/Total initial investment

All business and projects cannot be very profitable. We need to accept the fact that it is not possible to get very high returns by investing in any one sector of the economy. There are some sectors which have consistently outperformed, whereas there are others who have lagged behind to a great extent. With the help of this formula and general explanation, we can determine which business would be the one in which investment will be rewarding. Businesses which do not take the importance of the profitability index into account, are bound to suffer from heavy losses.

Demand forecasting is certainly difficult, but with tools like profitability index being available, the job of managers has become somewhat easy.
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