Loading the player...

What is the 'Profitability Index'

The profitability index is an index that attempts to identify the relationship between the costs and benefits of a proposed project through the use of a ratio calculated as:

Profitability

A profitability index of 1.0 is logically the lowest acceptable measure on the index, as any value lower than 1.0 would indicate that the project's present value (PV) is less than the initial investment. As the value of the profitability index increases, so does the financial attractiveness of the proposed project.

BREAKING DOWN 'Profitability Index'

Profitability index is an appraisal technique applied to potential capital outlays. The technique divides the projected capital inflow by the projected capital outflow to determine the profitability of a project. As indicated by the formula above, the profitability index uses the present value of future cash flows and the initial investment to represent the aforementioned variables.

When using the profitability index to compare the desirability of projects, it's important to consider that the technique disregards project size. Therefore, projects with larger cash inflows may result in lower profitability index calculations because their profit margins are not as high.

Components of the Profitability Index

PV of Future Cash Flows (Numerator): The present value of future cash flows requires the implementation of time value of money calculations. Cash flows are discounted the appropriate number of periods to equate future cash flows to current monetary levels. Discounting accounts for the idea that the value of $1 today does not equal the value of $1 received in one year because money in the present has more earning potential – via interest-bearing savings accounts for instance – than money yet unavailable. Cash flows received further in the future are therefore considered to have a lower present value than money received closer to the present.

Investment Required (Denominator): The discounted projected cash outflows represent the initial capital outlay of a project. The initial investment required is only the cash flow required at the start of the project; all other outlays may occur at any point in the project's life, and these are factored into the calculation through the use of discounting in the numerator. These additional capital outlays may factor in benefits relating to taxation or depreciation.

Calculating and Interpreting the Profitability Index

Profitability index calculations cannot be negative and must be converted to a positive figure before they are useful. Calculations greater than one indicate the future anticipated discounted cash inflows of the project are greater than the anticipated discounted cash outflows. Calculations less than one indicate the deficit of the outflows is greater than the discounted inflows and the project should not be accepted. Calculations that equal one bring about situations of indifference where any gains or losses from a project are minimal.

When using the profitability index exclusively, calculations greater than one are ranked based on highest calculation. When limited capital is available and projects are mutually exclusive, the project with the highest profitability index is to be accepted as it indicates the project with the most productive use of limited capital. Profitability index is also called the benefit-cost ratio for this reason. Although some projects result in a higher net present value, those projects may be passed over because they do not have the highest profitability index and do not represent the most beneficial usage of company assets.

RELATED TERMS
  1. Initial Cash Flow

    Initial cash flow is the amount of money paid out or received ...
  2. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present ...
  3. Rate of Return

    A rate of return is the gain or loss on an investment over a ...
  4. Discounting

    Discounting is the process of determining the present value of ...
  5. Net Present Value Rule

    The net present value rule (NPV) states an investment should ...
  6. Discounted Payback Period

    A capital budgeting procedure used to determine the profitability ...
Related Articles
  1. Investing

    An Introduction To Capital Budgeting

    We look at three widely used valuation methods and figure out how companies justify spending.
  2. Small Business

    How to Calculate Net Present Value (NPV) in Excel

    Learn how to calculating the net present value (NPV) of your investment projects using built-in functions from Excel.
  3. Personal Finance

    10 Ways to Improve Cash Flow in Construction

    Improving cash flow in construction requires some sector-specific strategies.
  4. Personal Finance

    Project Manager: Job Description & Average Salary

    Discover more about the specific tasks that project managers are responsible for and the average salary that can be expected in such a position.
  5. Investing

    Analyze cash flow the easy way

    Learn the key components of the cash flow statement, how to analyze and interpret changes in cash, and what improved free cash flow means to shareholders.
  6. Investing

    Value Investing: Why Investors Care About Free Cash Flow Over EBITDA

    Examine value investing philosophy and methodology to see why free cash flow is more important than EBITDA in pure intrinsic value calculation.
  7. Investing

    Top 3 Pitfalls Of Discounted Cash Flow Analysis

    The Discounted Cash Flow (DCF) method can be difficult to apply to real-life valuations. Find out where it comes up short.
  8. Investing

    Free cash flow yield: The best fundamental indicator

    Cash in the bank is what every company strives to achieve. Find out how to determine how much a company is generating and keeping.
  9. Personal Finance

    A project manager's qualifications and career path

    Learn about a project manager's job, the qualifications necessary for the position, and the most common careers for these professionals.
RELATED FAQS
  1. What is the difference between present value and net present value?

    Understand the difference between the present value and net present value calculations and how these formulas are used in ... Read Answer >>
  2. How do you use the profitability index rule when scoping out a project?

    Understand the parameters of the profitability index rule and how this rule is used in corporate capital allocation to determine ... Read Answer >>
  3. What's more important, cash flow or profits?

    Learn about the different effects of cash flow and profit have on a business and how you can use the information for your ... Read Answer >>
  4. Do you include working capital in net present value (NPV)?

    Discover why it is important to include changes to working capital as a component in calculating the net present value (NPV) ... Read Answer >>
Hot Definitions
  1. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  2. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  3. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  4. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  5. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
  6. Inventory Turnover

    Inventory turnover is a ratio showing how many times a company has sold and replaces inventory over a period.
Trading Center