The PI (Profitability Index) is used for measuring the ratio between the present values of the upcoming cash flow with the initial investment. It is often compared along with the Net present value method for finding out the close proximity. The Index acts as a tool for ranking out the investment projects that is used for generating the value that is created per unit of investments.
The PI is mainly used for ranking projects when the value is higher than, then it is considered as the attractive proposed projects. For a single project the PI value 1 or greater than that is acceptable. The Profitability Index is called as the PIR (Profit Investment Ratio) or VIR (Value Investment Ratio). It acts as a best appraisal techniques that is applied for the potential capital outlays for ranking out the projects financial outlook, it allows the investors for quantify the amount value created as per the unit of investment.
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What is the formula that is used behind for calculation?
PI = Present value of the upcoming cash flows / starting investment that you do.
PI = (Present value of Net + The initial investment) / the initial investment.
This formula looks so simple and all you want to do is for finding out the present value of the future cash flow and then it is required for you to divide out the initial investment of your projects. Another method that you can use for determining is the NPV method.
For calculating the NPV (Net Present Value) for that first the cash inflows along with the cash outflows is noted. Then the appropriate discount rate is determined. The user of the discount rate that is present in the value of all cash inflows as well as the outflows. After that the sum of all the present values are taken. This method is used for determining the comparison for finding out the alternatives method for calculating the profit.
The interpretation of profitable index is calculated based on the following rules
- When the index is more than 1 – The investment that you do is considered as worthy. It creates a chance for you to earn the amount that you have invested in it.
- The index is less than one – Prevention is always better in this case you can step back for looking out for the other opportunities that is available for you over there. It is because even when you invest you cannot expect the returns.
- If the index is equal to 1 – Then it is considered as the neutral project.
Through calculating it one can easily determine about the profit that the business firms can obtain based on investments.
What is the need for you to use the PI in business firms?
- It is used for determining whether the investment is required for you to run the business or not.
- The PI is used for calculating out the value of the money and to predict out the risk of the futures.
- It is better choice for ranking and choosing out the project when the capital is rationed.
Magalie D. is a Diploma holder in Public Administration & Management from McGill University of Canada. She shares management tips here in MGTBlog when she has nothing to do and gets some free time after working in a multinational company at Toronto.