How to Calculate a Profitability Index

by Gerald Hanks; Updated September 26, 2017

The goal of every business is for each aspect of that business to contribute to its bottom line. It's important for a business owner to be able to determine if a capital investment in the company today will reap a profit in the future. The profitability index measures the relationship between the current costs of a capital investment and its potential benefits. A profitability index of 1.0 indicates a capital investment as a "break-even" proposition, while those with lower ratios reflect investments that will not deliver sufficient returns.

Present Value of Future Cash Flows

A determining factor in calculating the profitability index is the present value of future cash flows the investment is expected to return. The present value formula measures the current value of a future amount to be received, given a specific time period and interest rate.

The present value can be calculated by the formula:

Vp= Vf / (1 + r)n

where

Vp= Value (present)

Vf = Value (future)

r = Interest rate

n = number of years

For instance, if an investment is expected to return $100,000 over 3 years at 3.5 percent interest, the present value calculation would look like this:

Vp= 100000/(1+0.035)3 = 100000/1.109 = $90,194.27

The calculation shows that $90,194.27 invested today at a 3.5 percent annual interest rate will be worth $100,000 three years from now.

Net Present Value

The net present value, or NPV, is the present value of future cash flows from that investment, less the amount invested. The NPV shows the difference between what the business would be required to spend to deliver the desired return and what they would actually spend. The NPV uses the time value of money to determine if the amount spent now to deliver a future return will result in a profit. For example, if the actual amount invested is $85,000 and the present value of future cash flows is $90,194.27, the NPV is (90194.27-85000), or $5,194.27. The positive NPV shows that the investment will deliver a profit.

Calculation of Profitability Index

While the NPV shows if the investment will yield a profit (positive NPV) or a loss (negative NPV), the profitability index will show the degree of the profit or loss. Business owners can use either the Present Value of Future Cash Flows (PV) or the Net Present Value (NPV) to calculate the profitability index.

Profitability Index = (PV/Amount Invested) = 1 + (NPV/Amount Invested)

Using the example, a company expects to receive $100,000 three years from now on an $85,000 investment. The interest rate is expected to stay at 3.5 percent for those three years.

Profitability Index (PV) = ($90,194.27/$85,000) = 1.061

Profitability Index (NPV) = 1 + ($5,194.27/$85,000) = 1.061

Uses for Profitability Index

Business owners employ the profitability index to determine if a capital investment will be a profitable use of its resources. Investments with high profitability indexes can help a business earn maximum profits with a minimum of investment.

The previous example, with a profitability index of 1.061, would likely be considered a marginal investment. If the time span were extended from three years to five years, the PV calculation would look like this:

Vp= 100000/(1+0.035)5 = 100000/1.188 = $84,197.32

and the Profitability Index calculation would look like:

Profitability Index (PV) = ($84,197.32/$85,000) = 0.991

making it a marginally losing investment.

About the Author

Living in Houston, Gerald Hanks has been a writer since 2008. He has contributed to several special-interest national publications. Before starting his writing career, Gerald was a web programmer and database developer for 12 years. He also started Story Into Screenplay, a screenwriting blog at www.StoryIntoScreenplay.com.