Also known as value investment ratio (VIR) and profit investment ratio (PIR), profitability index (PI) refers to the future earnings to be derived from a primary investment. This indicator is commonly used in projecting the flow of income from investments with limited capital. If you have several investments, by calculating their profitability indices, you will know which one has the highest P.I. and therefore this finding will help you decide which investment should be allotted more resources. These are the ways by which you can explain profitability index:
- Know the type of investment and the time frame involved in its initial stage. Is it a small-scale industry or a medium-scale one? Are you going for sole proprietorship or a corporation? Is the business franchised or pioneered? These guide questions will more or less direct you in determining the profitability index of an investment.
- Collate the information needed to estimate the probability index. Find out the amount needed for the initial investment.
- Take into consideration some factors that may affect the initial investment at the time it is set to actual venture. This is important if you are calculating the profitability index of a business that is yet to be started. The period on which the business is launched determines the value of the capital appropriated for investment. For instance, if you are doing the profitability index calculation today for an investment that will probably begin in two years, you should allow a margin of error for currency depreciations.
- Use this formula in computing the profitability index or the net cash inflow of the initial investment: Profitability Index = Present Net Value of Future Income/Initial Investments. In order to determine future cash flows, a business model or plan is necessary. Such business plan should be able to describe the different investment activities within a certain period of time such as the amount invested, the conduct of sales and the demand of the services or products involved in the business.
- Look very closely at the outcome of your calculation. If it yielded a probability index that is higher than one, the investment is good and it is safe to put your money in it. On the other hand if the results yielded shows a profitability index lower than one, it is not advisable to push through with the venture. Meanwhile if the profitability index is equivalent to one, the investment will neither lose nor earn money which means it is just on a break even status. In this latter case, the investment may still be pursued, if there are promising indications that it will grow in time and eventually earn profits.
- Make a comparative study of the investment packages on hand. List them all in consecutive order according to their profitability indices.
- Decide which investment to capitalize in. Base your decision on the list you made. Of course the one with the highest profitability index is the wisest investment undertaking. The ratio is illustrated this way: for a profitability index of 1.5, the potential earning for every dollar invested is $1.50.
In choosing which investment to embark on, make sure to include the risk factors involved. Even if the profitability index is high, take a look still at the prevailing economic conditions and how they will affect future investments.