The profitability index of an investment by a company is an indication of the costs and benefits of investing in a particular capital project by a business firm. It is a cost/benefit ratio used in capital budgeting financial analysis.
What is the Profitability Index Formula?
The profitability index can be calculated by dividing the present value of future cash flows expected to be generated by a capital project by the initial cost, or initial investment, in the project. If the result is less than 1.0, you do not invest in the project. If the result is greater than 1.0, you do invest in the project. If the profitability index of a project is 1.2, for example, you can expect a return of $1.20 for every $1.00 you invest in the project.
Here is the formula:
Profitability Index = Present Value of Future Cash Flows Generated by the Project/Initial Investment in the Project
In other words, if the result is greater than 1.0 and the owner invests in the project, then the company will benefit financially and make a profit if the business owner invests in the project.
How is the Profitability Index Used?
The profitability index is often used to rank a firm's possible investment projects. Since company's usually have limited financial resources, they invest in only the most profitable projects. If there are a number of possible investment projects available, the company can use the profitability index to rank those projects from the highest profitability index to the lowest to decide in which to invest.
One problem with using the profitability index is that it does not allow a business owner to consider the size of the project when evaluating projects. Using the net present value method of evaluating investment projects solves this problem.