We recently discussed how revenue should be recognized in a SaaS company, comparing it to bookings and billings, and it’s pretty straight forward.
Profit is harder to define. There are multiple ways to keep track of it, with metrics such as Operating Income, Net Income, Free Cash Flow, Cash Flow or something else. Often investors utilize these metrics to identify the best stocks to buy right now, leveraging the market conditions to maximize their profits.
The three most common metrics used to measure a SaaS company profit are EBITDA, Gross Margin and Net Profit. Let’s explain in details each one of these metrics.
When analyzing financial health, accountants and investors alike closely examine a company’s financial statements and balance sheets to get a comprehensive picture of its profitability. There are a number of metrics and corresponding financial ratios that are used to measure profitability. Typically, analysts look to the standardized profitability metrics outlined in the generally accepted accounting principles, because they are easily comparable across businesses and industries, but some non-GAAP metrics are widely used.
One such non-GAAP metric is earnings before interest, taxes, depreciation, and amortization (EBITDA). This calculation is used to measure a company’s operational profitability because it takes into account only those expenses necessary to run the business on a day-to-day basis.
EBITDA is a way to measure profits without having to consider other factors such as financing costs (interest), accounting practices (depreciation and amortization) and tax tables. Calculating EBITDA is usually a fairly simple process and, in most cases, requires only the information on a company’s income statement and/or cash flow statement.
Why does EBITDA make sense for SaaS
If your product infrastructure is running on the cloud, calculating EBITDA should be pretty simple and consistent. However, if you are running your own infrastructure, your EBITDA, Operating Income and Free Cash Flow will diverge from your Net Income and Cash Flow because of equipment purchases, debt to finance them, or lease expense.
It turns out 99% percent of the SaaS companies run on the cloud.
EBITDA can also be used to analyze the profitability between companies. Because it eliminates the impact of financing and accounting decisions, using EBIDTA provides a good “apples-to-apples” comparison. For example, EBITDA as a percent of sales can be used to find companies that are the most efficient operators (the higher the ratio, the higher the profitability) in an industry.
EBITDA can be used to compare the profitability trends of “heavy” industries (like automobile manufacturers) to hi-tech companies because it removes the impact of interest expense and depreciation from the analysis.
How to calculate EBITDA
The earnings, tax and interest figures are found on the income statement, while the depreciation and amortization figures are normally found in the notes to operating profit or on the cash flow statement. The usual shortcut to calculate EBITDA is to start with operating profit, also called earnings before interest and tax (EBIT), and then add back depreciation and amortization.
EBITDA = Operating Profit + Amortization Expense + Depreciation Expense
You could also use the traditional EBITDA formula, although it’s harder to calculate:
EBITDA = Revenue – Expenses (excluding taxes, interest, depreciation, and amortization)
While EBITDA may be a widely accepted indicator of performance, using it as a single measure of earnings or cash flow can be very misleading. In the absence of other considerations, EBITDA provides an incomplete and dangerous picture of financial health.
Clearly, EBITDA does not take all of the aspects of business into account, and by ignoring important cash items, EBITDA actually overstates cash flow. Even if a company just breaks even on an EBITDA basis, it will not generate enough cash to replace the basic capital assets used in the business.
Treating EBITDA as a substitute for cash flow can be dangerous because it gives investors incomplete information about cash expenses. If you want to know the cash from operations, just flip to the company’s cash flow statement.
Worst of all, EBITDA can make a company look less expensive than it really is. When analysts look at stock price multiples of EBITDA rather than bottom-line earnings, they produce lower multiples. Consider the wireless telecom operator Sprint Nextel. On April 1, 2006, the stock was trading at 7.3 times its forecast EBITDA. That might sound like a low multiple, but it doesn’t mean the company is a bargain.
As a multiple of forecast operating profits, Sprint Nextel traded at a much higher 20 times. The company traded at 48 times its estimated net income. Investors need to consider other price multiples besides EBITDA when assessing a company’s value.
The gross margin represents the percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services sold by a company. The higher the percentage, the more the company retains on each dollar of sales to service its other costs and obligations.
To calculate the Gross Margin, you need to understand your COGS.
Cost of Goods Sold
Cost of goods sold, or COGS, for SaaS companies seems like it should be a straightforward topic but there are a number of different conflicting reports online. According to Wikipedia, the cost of goods sold “refers to the inventory costs of the goods a business has sold during a particular period.” Of course, due to the nature of software, there is no inventory but there are costs to deliver the application.
Here are the most common items to be included in the COGS calculation for a SaaS company:
- Hosting fees (our highest expense after salaries and benefits);
- Third-party web fees like content delivery networks, embedded software, etc;
- Support personnel costs;
- Customer on-boarding and success costs (e.g. client implementation personnel costs);
Note: Credit card fees and other billing fees often are no cost of goods sold for SaaS companies and are instead general and administrative fees.
Keep in mind that things like software development costs, customer acquisition costs, and more aren’t included since they are not required once the customer has already been signed. SaaS cost of goods sold is an important metric so that gross margin can then be calculated.
An easy way to understand COGS is to think of the costs that scale with the number of customers you have. Let’s say you acquire 100 new customers next month. Unless you plan to build new features you don’t necessarily need to grow your product team, right? But you’ll probably need to grow your support team to handle new support tickets from the new customers. That’s why support personnel costs are part of COGS.
How to calculate Gross Margin
The calculation of the Gross Margin is pretty simple and straightforward.
Gross Margin = Revenue – COGS
You can also calculate Gross margin as a % value, meaning the percentage of the revenue that is left after COGS is deducted. Software companies tend to have Gross margins as high as 80~90%.
Gross Margin % = Gross Margin / Revenue
It’s also common to name the dollar amount Gross Profit and the percentage amount Gross Margin.
Keep in mind that in some countries such as Brazil, there are some specific sales taxes that hit the P&L statement. That happens because taxes are deducted directly from the revenue source, and because of that, instead of using Revenue, you should use Net Revenue (revenue after taxes).
Often referred to as the bottom line, net profit is calculated by subtracting a company’s total expenses from total revenue, thus showing what the company has earned, or lost, in a given period of time.
Net profit is a more accurate measure of a company’s profitability, as it reveals the amount of revenue that actually reflects a company’s profit. Net profitability is an important distinction since increases in revenue do not necessarily translate into actually increased profitability.
How to calculate Net Profit
Net profit is the gross profit (revenue minus cost of goods) minus operating expenses and all other expenses, such as taxes and interest paid on debt. The formula for net profit margin is as follows:
Net Profit = Revenue – COGS – operating expenses – other expenses – interest – taxes
You could also Net profit margin as a percentage value, using the following formula:
Net Profit Margin % = Net Profit / Revenue
Running a successful SaaS company is difficult, assessing its current success shouldn’t be as difficult. Comparing the revenue growth and profitability can tell you most of what you need to assess the company’s current position.
These key metrics should be assessed with regards to the stage of the company. In the early stages of a company’s growth, operational efficiencies have not yet been reached, and early sales are expensive. If the trends are favorable, the early stage SaaS company can transition into having a more successful profile with these key metrics.
Please keep in mind that many other metrics should be considered to evaluate your company’s profit, just make sure not to leave any of these three behind.
If you have any comments or doubts please feel free to comment and I’ll be happy to help and discuss.