What is the Profitability Index formula? Learn how to calculate!

Are you sure that your business is actually generating profit? Want to know what your profitability is in front of your competitors?

For this, there is the Profitability Index! Have you ever heard of this indicator? If you have not heard, do not worry, I'll teach you everything you need to know!

The secret to these and other issues you discover here, just keep reading! Ready to start?

What is the Profitability Index Formula?

The Profitability Index (PI) is the perfect indicator for you who wants to know your company's ability to generate profits from the project. This indicator will show you whether the project is feasible and / or needs to be improved, and in the worst case, discarded.

So, to avoid investing in a business that does not return the desirable profit, learn to calculate this rate of profitability and how to interpret it.

First, it is necessary to know that this indicator is fundamental for a business since it allows an entrepreneur to know the efficiency of the company in generating a profit. This index can be broadly calculated covering all sectors of the company, as well as individually, to measure the profitability of a specific industry.

You may be wondering if the utility of this indicator is limited only to measuring profit generation, right? The answer to this question is no since this indicator is also an important tool for decision making by managers of a company. From it, it is possible to evaluate if the adopted strategies are working well and what changes are necessary.

Profitability Index = PV of future cash flows / Initial investment

It can be further expanded as below,

Profitability Index = (Net Present value + Initial investment) / Initial investment

Profitability Index = 1 + (Net Present value / Initial investment)

Profitability Index Formula= PV of Future Cash Flows/Initial Investment

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How to calculate the Profitability Index?

Simple Calculation

Are you with your calculator at hand? It is important to be because I am going to teach you how to calculate the Profitability Index. If necessary, take a quick pause in the reading to get your calculator.

The PI is the abbreviation for this indicator and can be found by the ratio of total revenue to net income, as you can see below:

Before you start calculating, it is important for you to know what revenues are the amounts from payments received for the products and/or services offered and the net profit is the value obtained after the discount of all costs, expenses and taxes.

So we can see these values from the following Profit and Loss Statement:

Now that we already know what the revenues and net income are and we identify these values in the above Profit and Loss Statement, we can start with our calculation. Let's see:

In this way, we see that the example given has a profitability of 169.68%, that is, this is the company's ability to generate profit from its operating activities.

You must be wondering why I multiplied the IL result by x 100, right? You will end up realizing that this is very common when using financial indicators because it facilitates the interpretation of the result and helps in the decision making by bringing the result in percentage.

Detailed Calculation

You can see that from the previous calculation, it was very simple to find the Profitability Index. However, this formula is not enough when we want a more precise value, that is, when we want to evaluate in a more detailed way the gain that a company can generate from its activities.

Therefore, large companies and financial professionals use the following formula:

The formula above considers as the numerator the cash flow added to the residual value of the investment, while the denominator is the investment itself.

To facilitate this calculation, you should ideally use a financial calculator. I bet you're asking yourself: What now? I do not have a financial calculator! Stay calm, there are applications with the financial calculator that you can download easily on your mobile.

But even without a financial calculator, you can develop the calculation, it will only take a little longer! Another way is to use Excel and if you are not aware of this software, you can start learning by doing our Introductory Excel.

Now let's take a practical example, imagine the following situation: A project will require an investment of $ 80,000.00, occurring on date zero. Considering an analysis period of 3 years and a rate of 8% per year. The estimated cash flow will be shown below:

Is this project advisable or not?

From the data provided in this example, we first calculate the Net Present Value (NPV). To do this, you need to pick up the cash flows that are projected and bring them to the year zero, this being known as discounted cash flow.

In this way, we have highlighted in red the calculation of the discounted cash flow. Did you look at the picture and still could not understand how I got these values? Calm! I will do the calculation in a more detailed way so you can understand and reach the same values. Let's see:

Now that you have really understood how to calculate the discounted cash flow, you can get the Present Value, which is nothing more than the sum of the values found previously:

With all the information at hand, you are able to easily calculate the IL and To know whether or not to recommend the project, note:

Thus, we can see that we have a Profitability Index of 171.96% when we multiply by 100 to obtain the percentage and we can say that it is a recommendable project for having IL > 1.

Interpretation of IL

Now that you know how this profitability ratio is calculated and how important it is, let's learn how to interpret that result.

The interpretation of this indicator is very simple. As we have seen, when IL > 1, the project is recommended because for every $ 1.00 invested you will get a higher return than your investment. In the case where IL < 1, the opposite happens, you will have a lower return on your investment, so a project is not recommended in this condition.

Thus, we can conclude that the larger the IL, the better your return on investment will be.

Advantages and disadvantages of the Profitability Index

Now that you know almost everything about this indicator, it is important to highlight its advantages and disadvantages.

Among its advantages we can highlight that this indicator considers the value of money in time, that is, this indicator takes into account that the value of something today will not have the same value in the future and, therefore, the IL considers interest and time.

Another advantage of IL is that it analyzes projects with constant disbursements well because in a project it is usually necessary to carry out more than one disbursement and all of them are considered in this calculation.

As a disadvantage, we can talk about how much the calculation can turn out to be laborious because in the most detailed way we have to make use of the financial calculator or software like Excel. However, it is important to note that although it is more complex, it is not difficult, and with a little more time you can even do it on the scientific calculator.

In addition, another disadvantage to be highlighted is that all inputs are remunerated from the same rate, as we saw in the example with the more detailed calculation, where a rate of 8% per year was adopted for the three years of the problem. But in other cases, these rates may vary.

Understanding what is Profitability Index and how to calculate it?

I hope you have understood everything about the Profitability Index. As you have seen, although it is a little hard work, it is not difficult to calculate and can help you a lot to see how efficient your company is in converting revenue into profit.

If you liked this reading, keep following our blog, as we have many other articles on Financial Management and other areas that will assist you in your projects.

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