What is the Profitability Index?

Profitability is a major decision-maker while evaluating the project in financial management in different phases of the project life cycle. Profitability as a decision criterion is another important tool in financial management for taking decisions at the various levels of the project. The Profitability Index is the proportion between the rate of the present value of the future cash benefits at the required rate of return to the initial cash outflow of the investment. The profitability index method is also known as Profit Investment Ratio (PIR) or Value Investment Ratio (VIR).

Profitability Index Formula 

Profitability Index Formula is as follows-

Profitability Index = PV of Future cash flows ÷ Initial cash investment

Where

PV of Future cash flows means the present value of cash flow that will be received at the future rate. 

Initial cash investment means the cash invested at the beginning of the project.

To determine whether the project must be accepted or not, the first profitability index must be computed in the order given above. Then if the ratio is equal to or greater than one, it shows that the project has an expected yield equal to or greater than the discount rate. If the index is less than one, it indicates that the project has an expected yield less than the discount rate. If the projects are selected from one or more alternatives, then the project must be ranked with the highest index as a priority and then similarly allocate further projects.

Importance of Profitability Index

The choice of project plays  an important role in an organisation as it determines the success in conjunction with the various factors determining its failure.Profitability index gives ranking to the projects available for choice and based on it the rejection or selection of project takes plays. So the future inflow of the project must be maximum from all the projects available by taking into consideration the initial investment. This simply states that the profitability index of the project must be greater than one which means that the future outflow will be more in comparison with its initial investment.