If you are an investor and considering investing your money in a SaaS company (Software as a Service), it is almost inevitable that you’ll have to check the company’s revenue, one way or another. However, profit is often quite difficult to define but 3 metrics can be used to track such data. The three most common metrics used to calculate a SaaS company’s profit are EBITDA, Gross Margin, and Net Profit. Let’s go over each of these metrics in greater detail down below.
What is EBITDA and how to calculate it?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. This calculation is used to assess a company’s operational profitability because it only considers the expenses required to run the business on a daily basis. In other words, EBITDA is a method of calculating profits that do not need to consider other factors such as financing costs (interest), accounting practices, and tax tables. Calculating EBITDA is typically a simple process that requires only information from a company’s income statement and/or cash flow statement.
EBITDA = Operating Profit + Amortization Expense + Depreciation Expense
Caution to use EBITDA
While EBITDA is a commonly accepted performance indicator, using it as a single metric of earnings or cash flow can be extremely misleading. In the absence of other metrics, EBITDA could be an insufficient and potentially dangerous picture of financial health. Clearly, EBITDA does not account for all areas of the business, and by ignoring important factors, EBITDA can overstate or understate the cash flow of a company. Even if a firm only breaks even on an EBITDA basis, it will not produce enough cash to replace the business’s basic capital assets.
What are Gross Margin and COFG?
The gross margin is the percentage of total sales revenues retained by a company after deducting the direct costs of productions/manufacturing of products and services sold. The higher the percentage, the more money the company keeps from each dollar of sales to cover its other costs and obligations. To calculate the Gross Margin, you must first understand your cost of goods sold. The cost of goods sold means the inventory costs for goods sold by a company during a specific time period.
The following are the most common items to include in a SaaS company’s COGS calculation:
- Hosting fees (your highest expense after salaries and benefits)
- Fees for third-party web services such as content delivery networks, embedded software, and so on
- Personnel costs for support and maintenance
- Costs associated with customer onboarding and success
*Please take note that credit cards and other billing fees are often not included in the cost of products sold for SaaS businesses, but are rather separated in their own category as general and administrative costs.
How to calculate Gross Margin?
In order to calculate the gross margin, you can use this easy calculation below:
Gross Margin = Revenue – COGS
You can also calculate Gross margin as a percentage, which is the percentage of revenue that appears after deducting COGS. Gross margins in software companies can sometimes reach as high as 80% to 90%.
Gross Margin % = Gross Margin / Revenue
Please remember that in some countries, there are specific sales taxes that are reflected in the profit and loss statement. This occurs because taxes are deducted directly from the revenue source, and as a result, you should use the Net Revenue rather than the Gross Revenue (revenue before taxes).
What is Net Profit and how to calculate it?
To put it simply, net profit is calculated by subtracting total expenditures from total sales to determine how much money a corporation has made or lost for a given period of time. The amount of income that actually represents a company’s profit is revealed by net profit, which is a more reliable indicator of profitability. Net profitability is an important distinction since increases in revenues do not always translate into increased profitability. The gross profit (revenue minus cost of goods) is subtracted from operating expenses and all other costs, such as taxes and debt interests. There are two formulas that can be used for efficiently calculating your net profit margin:
Revenue – Cost of Goods Sold – Operating Expenses – Other Expenses – Interest – Taxes = Net Profit
Net Profit Margin (%) = Net Profit / Revenue
To conclude, we won’t beat around the bush, running a profitable SaaS business is a difficult endeavor, but judging and leveling its current financial performance shouldn’t be. Much of what you need to know about the company’s current status can be found by comparing sales growth and profitability. The 3 primary metrics we presented should be measured before any investment is even in a discussion. Indeed, a company’s operational efficiencies might not be achieved yet, especially in its early stages of development. On that note, we wish you good luck in your next investment or next project.