How to Explain Profitability Index

Profitability index is a finance term that tells us the potential payoff of an investment compared to the initial cost of investing. Profitability Index, often abbreviated as P.I., is a great indicator of how good of an investment you are making. It's especially useful if you can only invest a limited amount. You can calculate the Profitability Index for multiple investment possibilities, and the one that has the highest P.I. value is the one where you should focus your resources.

Instructions

1. Gather data required to calculate profitability index. You'll need to know the amount required for initial investment as well as the net present value of all expected future cash flows from the investment.

2. Calculate the profitability index of the potential investment using the following formula: Profitability Index = Net Present Value of Expected Future Cash Flows / Initial Investment.

3. Examine the results. If the profitability index you calculated is greater than one, this is a good investment and you should invest your money in this venture. If the profitability index is less than one, this is a bad investment and you should not invest. A profitability index equal to one means that you will break even on the investment, so you will not make or lose any money.

4. Compare your investment choices. Rank each investment in descending order by it's profitability index.

5. Choose your investment. After you have determined the profitability index of all of your possible investment scenarios, you can choose which will be the most profitable. Simply choose the investment with the highest profitability index. An investment with a profitability index of 1.1 will earn you $1.10 for every dollar you invest, while an investment with a probability index of 1.6 will earn you $1.60 for every dollar you invest.

Tips & Warnings

• Don't invest in any scenario where profitability index is less than one. A profitability index of less than one indicates that you will lose money on your investment.