How do you know when a project is worth the investment? When is it worthwhile to spend a significant amount of money on new equipment or other business improvements? To answer these questions many businesses rely on the profitability index.
What is the Profitability Index?
Sometimes the profitability index (PI) is also called a profit investment ratio. This figure can show the profit realized from investing in a project. It can also measure the return gained from capital expenditure.
The profitability index uses the initial investment into a project or expenditure, and future cash flows that are a result of that project or expenditure.
Why Do Small Business Owners Need to Know Their Profitability Index?
As an SME or individual entrepreneur, you know that you can’t afford to sink money into projects or expenditures if they aren’t going to payout. Basically, that’s why you should always keep an eye on your operating capital numbers and COGS.
While those numbers communicate the cost of doing business at the moment, the profitability index provides you with an outlook of the future. For instance, if you are exploring several new product types, calculating the profitability index for each one, can help you rank each option according to its potential.
The Key Advantages of Knowing Profitability Index
Check out the following advantages of using a profitability index to determine whether a project or capital expenditure is worthwhile.
- The profitability index will include all cash flows related to a project – both incoming and outgoing cash flows. Meaning that you’ll have a fuller picture of your biz.
- Assists you in evaluating costs and risks contrasted with investments.
- You will see how a particular investment impacts the value of your business.
- It provides you with a comparison of the current value of your money as well as future values.
Of course, one of the most important advantages of profitability is that it is relatively simple to calculate. Now that you understand the PI meaning, you can determine how to use it for decision-making.
How to Calculate Profitability Index
To get started, here is the profitability index formula:
Present Value of Future Cash Flows/Initial Investment = Profitability Index
(Net Present Value + Initial Investment)/Initial Investment = Profitability Index
Examples of Profitability Index
Here are some profitability index examples to better illustrate the formula application.
Acme Manufacturing has two projects on the table. They can only go forward with one, and want to make the best choice.
Project one involves an initial investment of $500,000. Here are the projected cash flows for the next seven years. The appropriate discount rate is 10%.
- First year: 50,000.
- Second year: 100,000.
- Third year: 300,000.
- Fourth year: 75,000.
- Fifth year: 125,000.
- Sixth year: 250,000.
- Seventh: 50,000.
To start, calculate the sum of the annual cash flows. 50,000 + 100,000 + 300,000 + 75,000 + 125,000 + 250,000 + 50,000 = $950,000.
Now, divide that by the initial investment 950,000/500,000 = 1.9. This means that this project does add value.
Project 2 involves an initial investment of $300,000. The projected seven-year cash flows look like this.
- First year: 10,000.
- Second year: 50,000.
- Third year: 100,000.
- Fourth year: 150,000.
- Fifth year: 20,000.
- Sixth year: 50,000.
- Seventh year: 10,000.
Once again, calculate the sum of the annual cash flows. 10,000 + 50,000 + 100,000 + 150,000 + 20,000 + 50,000 + 10,000 = $390,000.
Again, divide this sum by the initial investment. 390,000/300,000 = 1.3. This project also adds value. However, it is not projected to be as profitable as project 1.
In this case, since the company can only choose one project, their choice should be project one.
Here’s another brief example. No calculations are necessary. Imagine that your company has $1.5 million for capital investments. You are considering ten possibilities, but don’t have the funds for all of them. To determine how to move forward, you can calculate the profitability index for each potential expenditure. Then, choose the options with the highest profitability index until you hit your $1.5 million dollar investment cap.
So What Does Profitability Index Mean?
Now you know how to calculate the profitability index, here are the things you can take away from the final calculation.
- If you get a profitability index that is greater than one, the project or expenditure has the potential to generate value. You should consider moving forward with it.
- If the profitability index is less than one, the project has a negative impact on value. You should not proceed in order to avoid a loss.
- If the profitability index is equal to one, there is no loss or gain. In this case, you may proceed or not based on other factors.
With the project profitability index, the higher the number, the better the investment.
Wrapping IT Up
The profitability index is a simple formula to learn that offers you great insights into the potential value of investments and projects. Use this calculation to help you make the most profitable choices with your money and grow your business further!
Photo by Dennis Cortes