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Ascertain whether an investment is viable with computed input of ROI to allow an informed decision on investment management.
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Running a profitable business demands a lot of investments and assessing them for profitability is essential. The profitability index (PI), also known as profit investment ratio (PIR) is a method to describe the relationship between cost and benefits of a project.
Profitability index is a modification of the net present value method of assessing an investment's potential profitability. PI ratio compares the present value of future cash flows from an investment against the cost of making that investment.
The PI ratio calculations are based on the following formula:
If you don't fancy calculating the present value manually, you can use the present value calculator here.
In order to calculate the profitability index ratio you will require a calculator that can offer you quick results with a few inputs. Let's see below what the iCalculator's profitability index calculator will ask you to do this calculation:
On the basis of the above inputs, the calculator will provide you with the following results:
The profitability index calculator will not only show you the index value, it will also give you the detailed version of it, which includes the net present value and the expected cash flows of a project. Besides that, it offers:
The PI ratio uses the time value of money, which means that if you receive a payment today, you can reinvest it today, and start making profits immediately, rather than receiving the same amount on a later date.
The PI ratio will result in a number that is 1, less than 1 or bigger than 1. Generally the PI ratio of 1 is least acceptable as it represents the break even point of a project, which defines the point where total sales (revenue) equal to the total cost. A PI ratio of less than 1 is completely undesirable as it represents that a project will cost more than it is expected to earn.
Ideally the PI ratio of more than 1 is expected from the project, which means the value of future cash flows will be greater than the initial investments and it reflects the profitability of a proposed project.
The PI ratio uses discounting, the cash flows are discounted by an appropriate rate of return. This is the minimum rate of return expected from a project. Discounting of cash flows reflects the risk involved in a project.
There are some factors that affect this ratio such as absence skunk cost, difficulty in assessing the appropriate rate of return and the projects may be projected unrealistically positive. However, the profitability index ratio can be very helpful in assessing the profitability of the projects when used along with other measures of profitability assessment.
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