What is a Profitability Index?
A profitability index (PI), alternatively referred to as a profit investment ratio or a value investment ratio, is a method for discerning the relationship between the costs and benefits of investing in a possible project. It calculates the cost/benefit ratio of the present value (PV) of a project’s future cash flow over the price of the project’s initial investment. This formula is commonly written as PI = PV of future cash flows ÷ initial investment. The figure this formula yields helps investors decide on whether or not a project is financially attractive enough to pursue. A profitability index of 1 designates the lowest measure by which it is logically acceptable to pursue a project. A value lower than 1 suggests that the project’s possible value is lower than the initial investment. This means that the investor does not make a profit and should not invest in the project. A value exceeding 1 indicates financial gain, and as the number goes up, the investment becomes more attractive
Profitability index is the “rolling forward” of indices of profitability. For example, a company has a turnover of 30,000 and makes 5,000 profit. That gives it profit of 5/30ths or 1/6th. If next year is turns over 42,000 and makes a profit of 6,000 then it’s new “index” is 6/42 or or 1/7th. By dropping from 1/6th to 1/7th it has a negative index of 10 minus(10 divided by 7 mulplied by 6)8.57 so the profit index is -1.43. By redo-ing this calculation over the following years or months, you get the relationship between one year and the previous, and each period will give it’s own index. That shows the “trends” you’re looking for. If you need more technical stuff, try “linear programming” which works on “means” to calculate the same thing. Good luck.
