The Profitability Index (PI), also known as the profit investment ratio (PIR) or value investment ratio (VIR), measures the ratio between the present value of free cash flows (FCF) and the capital investment initially made on a project. Financial analysts can use this index to compare and rank investment projects based on the per unit value created.
Profitability Index FormulaThe formula for calculating the PI is: Profitability Index = Present Value of Future Cash Flows / Initial Investment or Profitability Index = (Net Present Value + Initial Investment) / Initial Investment
Interpretation of PIWhen a project has a PI >1, the project creates value and therefore a company should proceed with it. When a project has a PI =< 1, the project does not necessarily create value and the company should carefully consider whether or not to proceed with the project. Generally speaking, the higher the PI the more attractive the investment to investors.
Pros and Cons of Profitability IndexPI tells a company whether an investment would create or destroy value for the company. It is a good metric to use because it accounts for the time value and risk of future cash flows by using the cost of capital as the discount rate. In addition, it is frequently used to rank projects and therefore choose the optimal one. Nonetheless, the calculation of PI requires the use of an estimated cost of capital. When projects are mutually exclusive (meaning they require different initial investments), PI does not help companies identify the right decision.
Other Useful ResourcesRead CFI's guide on PI to learn more about the topic, implication, examples of calculating profitability index. Also feel free to browse around CFI Marketplace to find other useful accounting templates.