Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.
Ever wish there was an easy way to quickly calculate if a business endeavor was worth your time and resources? The profitability index method gives you just such a way to quickly check the nature of a project.
Is It Worth It?
As the owner of a small business, you're constantly faced with the prospect of having to make the best possible decisions for your organization. Some of these are pretty easy to make. After all, if a customer is knocked out by one of your employees for no reason, it's probably a good idea to fire that employee. Likewise, if a customer tries to steal your most expensive goods, then it's probably a good idea to file criminal charges against that individual. However, not every business decision is as clear-cut as those are. Sometimes, people who really want to see a decision come to fruition, may try to sugarcoat it in an attempt to make sure you make the call that they want to hear. Luckily, you have a secret weapon. By using the profitability index, business managers can quickly see if a decision will provide a profit, and thus be worth their time, or will fail to break even and thus should be avoided.
The Profitability Index
At the core, the profitability index is just a fraction. The profitability index is equal to the present value of future cash flows divided by the cost of the investment. Present value of future cash flows simply means the money that you expect to make from the investment. Of course, initial investment refers to the money that you have to put down to make that money.
Sometimes, you'll see another formula in which the net present value of the cash is instead used. All this refers to is that the cost of the investment is subtracted from the future cash flows. From there, it's divided by the initial investment. This is then added to one, to allow the following interpretations to still make sense.
Three possible outcomes are possible with the profitability index. The first of these is that the number you get is less than one. If this is the case, then you should avoid the investment! This is because the investment will cost more money than it will make back. In other words, it is a waste of money. The second outcome is that the number is equal to one. In this case, you'll absolutely break even - you won't lose money, but you won't make money either. However, the most desirable outcome is to have a number larger than one. This means that the new investment will actually make money, since the cash flow increases relative to the cost of the investment. In this case, you absolutely should put money towards this new investment. To not do so would be to just let money flow down the drain!
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That's quite a bit to absorb, so let's take a look at a couple of examples. In the first case, you have the opportunity to make a $10,000 investment that will make $15,000 in future cash flow. That would be $15,000 divided by $10,000, leaving us with 1.5 as our profitability index. Since it's above one, that makes it a good investment!
Let's take a look at an investment that may not be so smart. Let's say that instead of a $10,000 investment, it was a $30,000 investment. The profits stay the same at $15,000, however. That would be $15,000 divided by $30,000, leaving us with a profitability index of 0.5. In other words, this is a horrible investment!
Let's also make sure we can use the alternative way as well. Remember, the index takes the net profit and divides it by the initial investment, then adds one. For our first example, that would be $15,000 minus $10,000, then divided by $10,000. We end up getting 0.5, but since we add one, we get the same 1.5 as we had before. Likewise, for the second example we would subtract $30,000, the initial investment, from $15,000, the profit. That gives us negative $15,000, which we then divide by $30,000. We end up with negative 0.5, which we would add one to in order to get the same profitability index of 0.5.
In this lesson we took a look at the uses of the profitability index to determine if a potential investment was really a good idea. We learned that the profitability index can be calculated in two different ways. First, the profitability index is equal to the present value of future cash flows divided by the cost of the investment. Second, we learned that we could take the net profit of the new investment, divide by the investment amount, and add one, and get the same index. An index value of greater than one will make a profit, an index value of less than one will create losses, and an index value of exactly one will break even.
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