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Companies often use a profitability index to determine relationships between project costs and benefits. A ratio is common here to assess the cash inflows and outflows related to each project under review. The present value of cash flows is necessary in order to create a dollar-to-dollar comparison. Essentially, the profitability index has the same use in a company, though its application to many projects is possible. It is one additional tool to measure the financial returns and attractiveness of projects.
Present value calculations take future dollar amounts and adjust them back to current value in the present time period. The formula uses the company’s cost of capital in its calculation; this figure represents the interest rate for external debt or equity. Net present value is similar, although it may deduct future cash outflows from the expected cash inflows. Whichever method works best for project assessment is typically fine as the present value portion of the profitability index is crucial. Finance analysts and accountants can help prepare this formula using dollar estimates.
Once a company knows the annual expected cash flows for each project, the company will multiply each amount by its related discount factor. These factors are readily available in simple charts used by many finance or accounting employees. The total of all factored future cash flow amounts represents the total present value of expected cash flows, which will be the numerator in the profitability index ratio. The cost of a project is the total cash outlays required right now to get the project started. This number is the denominator of the index formula.
Dividing the present value of future cash flows by the initial investment will return an index figure. For the profitability index, 1.0 is typically the base figure for accepting a new project in terms of financial attractiveness. Figures below 1.0 typically indicate a loss as the cost of the project will be more than the expected financial returns. As the index figure increases over 1.0, the financial attractiveness for each project increases. Therefore, the highest numbers possible from the index are more favorable.
The profitability index can work with both cost savings projects and new cash-generating projects. For example, a company decides to purchase a machine that ultimately lowers operations costs. The attractiveness of cost savings can be decided through the profitability index. The attractiveness of new cash-generating projects is assessed as detailed above, which is perhaps the most common use of the index.