The profitability index shows how much a particular project will be profitable (relative), or how much money will come in the process of carrying out this project. In this case, only one investment unit is taken into account.
Investments and Profitability Index
Before you invest your money in a particular project, you need to try to determine which of the options will bring big profits and how much good benefit you get. It is in order to find out this information, and there is the so-called investment profitability index. This indicator is also called the profitability index, or PI.
What You Need to Know About Investment Profitability Index
With its help, it is possible to calculate without any problems what relation between current incomes and current expenses exists. At the same time, those funds that were invested in the project are also taken into account. In addition, the calculation can be both real (in this case, those funds that were received over the past period of time are calculated) and prognostic (when those incomes and expenses that will still take place) are taken into account.
If after calculations it turned out that PI is less than 1, then it can be argued that you received from investing in the project a net profit that is less than the funds that were invested in it. This gives the right to argue that such an investment was unprofitable.
If the investment profitability index is 1, then the project can be both profitable and not. But PI, which is more than one, means that you invested your money wisely and get a fairly large income. It is worth remembering that the greater the value obtained, the more stable and reliable the project is considered. Also remember that when calculating long-term projects it often happens that the initial profit may not be more than capital, so consider the time period.
Advantages and disadvantages of the index
The profitability index has its pros and cons. Among the advantages of this method, the most important is that it allows you to ideally distribute funds in time. In addition, it can be used to determine what effects a particular project has had over its entire existence, as well as to compare projects of different scale.
But he also has its drawbacks. For example, the profitability index makes it easy to rank projects that have different durations. But, despite all the disadvantages, it is with the help of PI that you can easily evaluate the effectiveness of sufficiently long-term investments and get the opportunity to calculate profit.
ROI formula
If we talk about how to correctly calculate PI, then here you will need a special formula that looks like this:
PI = PV in / PV out
or so
PI = 1 + NPV / PV out
In these formulas, PV in (NPV) means the net present value of the project, and PV out is the investment.
The profitability index, the formula of which was described above, does not mean that you will certainly receive the absolute size of the net cash flow, because it indicates only the ratio of investment costs.
If you are an investor and want to determine how successful this or that project will be, then you need to know that the higher the investment costs, the greater the amount of net cash flow that you plan to receive. Also, the amount will be affected by the so-called volume of investment costs for different time periods. It has an important influence on the amount of money flow and when the operational phase began. The discount rate has a significant impact on the cost of the main indicators of the project in the field of investment.