Advantages And Disadvantages Of Profitability Index

Accounting , Business
Advantages Of Profitability Index (PI)

Main benefits or advantages of using profitability index method of evaluating investments can be explained as follows:

1. Widely Used Technique

Profitability Index (PI) is very easy to calculate. So, it is common and widely used technique to evaluate different investment proposals.

2. Time Value Of Money

PI assumes that money received today is far valuable than the exact amount of money of future. So, it highlights the time value of money and evaluates the present value of money of future cashflows. 

3. Easy To Make Decision

It is simple and easy to find out the suitable investment project with the help of profitability index method. Project with higher PI is accepted and others are rejected.

4. Rate Of Return

Profitability index ascertains accurate rate of return of the project which is important to know the profitability of the project.

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5. Profitability

PI focuses on the profitability of the firm. It also considers the risk factor. It helps to maximize the value of the firm
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advantages disadvantages profitability index

Disadvantages Of Profitability Index (PI)

Major drawbacks or limitations of using profitability index method can be expressed as follows:

1. Estimation Of Cost Of Capital

It is difficult to estimate cost of capital and interest rate or discount rate to determine the profitability index of the project.

2. Comparison

It is difficult to compare the projects having different estimated working life.

3. Incorrect Decision

There is a chance of drawing incorrect decision while comparing mutually exclusive capital projects.
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Advantages And Disadvantages Of Net Present Value

Accounting , Business
Advantages Of Net Present Value (NPV)

Main benefits or advantages of NPV method of selecting most profitable capital project can be expressed as follows:

1. Time Value Of Money

One of the major benefits of using NPV method is that it considers time value of money. Future estimated cashflows are converted into present value because it assumes that money received in future is worth less than money received today.

2. Easy Decision Making

It is very easy to select the favorable project in net present value method. The capital project with positive NPV or higher NPV is selected and others are rejected.

3. Comparison

NPV compares different projects on the basis of cashflows. It selects the project with the higher NPV. So, it helps to maximize the value of the business.

4. Emphasis On Profitability

NPV method selects most profitable project. So, it focuses on the profitability of the firm which is in the favor of shareholders and owners.
advantages disadvantages NPV

5. Scientific Method

NPV method is scientific and most reliable technique of evaluating investment proposals.

Disadvantages Of Net Present Value (NPV)

Major drawbacks of limitations of NPV can be studied as follows:

1. Complicated Method

NPV method requires complex calculation. So, it is difficult to calculate and understand than traditional methods of evaluating capital projects. 

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2. Unsuitable

NPV method is not suitable for the comparison of projects with different sizes and different life.

3. Relies On Discount Rate

NPV is calculated with the help of discount rate. It is not easy to determine appropriate discount rate. 

4. Forecasting Problem

NPV is calculated on the basis of cashflows. It is difficult to forecast future cashflows of assets having longer life.
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Advantages And Disadvantages Of Accounting Rate Of Return

Accounting , Business
Advantages Of Accounting Rate Of Return (ARR)

Main benefits or advantages of accounting rate of return method of evaluating investment proposals can be studied as follows:

1. Simple Method

Accounting rate of return (ARR) is simple and widely used technique of comparing capital projects which can be understood easily by everyone.

2. Easy Calculation

It is very easy to calculate ARR of different projects. It can be determined by using simple formula which is given below.

Accounting Rate Of Return (ARR) = (Average Net Income/Average Investment) x 100

3. Simple Decision Rules

It is easy to take decision regarding the suitable capital project. Project with higher ARR is selected and project with lower ARR is ignored.

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4. Measures Profitability

ARR measures the profitability of a project which is beneficial for shareholders and owners.
advantages disadvantages ARR

Disadvantages Of Accounting Rate Of Return (ARR)

Main drawbacks or limitations of ARR can be studied as follows:

1. Ignores Time Factors

Accounting rate of return method does not consider time value of money. So, it is unscientific method of comparing capital projects.

2. Ignores Cashflow

ARR is calculated on the basis of profit earned by the project. It ignores cash-flows which is very important factor for every business.

3. Ignores Terminal Value

ARR ignores the terminal value of the project which is important in accounting. 
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Advantages And Disadvantages Of Payback Period

Accounting , Business
Advantages Of Payback Period (PBP) 

Main benefits or advantages of payback period method of evaluating investment proposal are as follows:

1. Simplicity

Payback period method is very simple to understand. It does not require specific knowledge and accounting rules to apply. So, it is universally applied method of evaluating proposals.

2. Easy To Calculate

Payback period is very easy to calculate. It can be determined by using simple formula given below:

Payback Period (PBP) = Investment/Annual Cash Flow

3. Easy To Make Decision

It is easy to select the suitable project with the help of payback period. The project with lowest payback period is selected and the project with longest payback period is rejected.

4. Suitable For Small And New Companies

Payback period method of evaluating investment proposals is suitable for small companies and new companies with less cash in hand or weak liquidity position.

5. Focus On Risk

This method emphasis on the risk factor. So, it is appropriate for those firms who do not take risk.

6. Emphasis On Liquidity

Payback period method emphasis on liquidity. So, it focus on speedy return back of investment.
advantages disadvantages payback period


Disadvantages Of Payback Period (PBP)

Major drawbacks or limitations of payback period method of evaluating proposals are as follows:

1. Ignores Time Value Of Money

Payback period method does not consider the time value of money. It is one of the major drawbacks of this method.

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2. Ignores Profitability

This method focuses on liquidity and speedy recovery of investment but completely ignores profitability.

3. Ignores Cash Flow After PBP

This method gives emphasis on the cash flow before payback period. It does not consider the cash flow after payback period.

4. Overlooks Capital Costs

Payback period method focuses on the cost of capital only. It ignores interest factor.
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Limitations Of Ratio Analysis

Accounting , Finance
Major limitations or disadvantages of ratio analysis can be studied as follows:

1. Based On Past Information

Ratio analysis is based on the financial statements which provide historical financial data and information. So, it may not be helpful in predicting the future of the business.

2. Ignores Qualitative Factors

Ratio analysis considers the monetary or quantitative aspects of the business. It does not address qualitative factors like quality, employee morale, customer satisfaction etc. which are essential for the success of the business. 

3. Chance Of False Result

Ratio analysis is based on the data and information received from financial statements. There are several limitations of financial statements also. So, ratios may provide wrong result because of wrong financial data.
limitations ratio analysis
4. Personal Bias

Ratio analysis may suffer from the personal bias of analyst because it is largely depends on the personal judgment.

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5. Fails To Disclose Current Worth

Ratios are based on historic data and information. So, ratio analysis does not disclose current worth of the company because of changes in price level.
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Advantages Of Ratio Analysis

Accounting , Finance
Main benefits or advantages of ratio analysis can be studied as follows:

1. Financial Position Analysis

Ratio analysis reveals the financial position of the company by analyzing financial statements. It explores the financial health of the business during a particular period.

2. Simplifying Figures

Ratio analysis makes accounting figures meaningful and understandable by everyone by simplifying and summarizing properly and systematically. 
advantages ratio analysis
3. Forecasting And Planning

Accounting ratios analyze the past financial performance of the business firm. Financial facts of previous period such as cost of good sold, sales, profit margin can be known with the help of ratio analysis. So, it can establish trend for future planning, forecasting and decision making.

4. Exploration Of Weakness

Ratio analysis judges the financial health of the business. It explores the weakness of the business which helps the management to take appropriate remedial measures.

5. Comparison

Ratio analysis helps to compare the financial performance of one firm with others. Inter-firm comparison helps to find out the strength or weakness of the firm and necessary steps can be taken for further improvement.

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6. Measurement Of Operational Efficiency

Ratio analysis helps to measure the working efficiency of the firm with the help of different ratios. Turnover ratio and profitability ratio help the management to know the operational efficiency and financial requirements of the company.

7. Credit Decision

Ratio analysis helps the creditors and investors to make credit decision by providing accurate financial position of the company.
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