When developing a business, whether it be a service or a software company, there are key equations that will come into play when trying to figure out your numbers. Three common metrics are used as a measure for a SaaS company (Software as a Service). These metrics are known as EBITDA ( Earnings Before Interest, Taxes, Depreciation, and Amortization), Gross Margin, and Net Profit. Let’s find out what they are and how to use them.
First and foremost, the EBITDA metric is used to calculate earnings before a company paid any of the interest, taxes, depreciation, and amortization. Therefore, it is an easy process that’s very useful for a company with multiple capital investments, debts, and tax profiles. Indeed, it allows one to compare those and to understand the company’s financial situation better.
How does EBITDA make sense for a SaaS company?
EBITDA should be, in general, simple to use for an infrastructure running on the cloud, which accounts for 99% of all SaaS companies. Moreover, this metric can be used to analyze the profitability between different companies and organizations. By providing this simple yet effective comparison, EBITDA removes the impact of accounting and financing decisions.
How to calculate EBITDA?
Of course, if you want to calculate this metric, you will need to understand its equation. The EBITDA equation goes like this:
Operating Profit + Amortization Expense + the Depreciation Expense
You can also use a more traditional formula, but this one is sometimes a bit more difficult to calculate:
EBITDA = Revenues – Expenses (excluding taxes, interest, depreciation, and annual amortization)
Before going any further
Even though EBITDA is a standard measure of profitability, it can also cause some mistakes in measuring earnings or cash flow. EBITDA alone is in fact, an incomplete picture of the financial health of a company. Even if you think that a company should be able to break even with the equation mentioned above, it doesn’t mean it actually can. That’s right, in such a case the revenues might not be enough to cover the expenses related to the basic capital assets used for the business.
As our second metric, we have the Gross Margin. This one is used to show the % of total sales revenues gained after incurring the direct costs associated with producing the goods and services sold by a company (COGS).
A high percentage from a Gross Margin calculation generally shows that a company will retain more on each dollar of sales. These gains will be then used to service other costs and obligations. But before you can fully take advantage of the Gross Margin metric, you need to understand the Cost of Goods Sold.
Cost of Goods Sold
Cost of Goods Sold (COGS) refers to the direct cost of producing goods sold by a company during a particular period of time. In terms of a software-related company such as SaaS, COGS is used for the costs of delivering the application. Of course, they’re usually (and obviously) no inventory for this type of company.
Four common items are used to calculate COGS in a SaaS company:
- Hosting fees are the highest expense after salaries and other benefits
- Personnel costs
- Customers on-boarding and success costs (client implementation personnel costs)
- Third-party web fees, for example, content delivery networks, or embedded software
COGS of SaaS companies do not include credit card fees and other billing fees, as they are included in general and administrative fees instead. Also, it is important to keep in mind that once the customer is signed up, there are no extra software development costs or any customer acquisition costs, which completely differ from a company selling a physical product or a service.
How to calculate Gross Margin
To calculate the Gross Margin:
Gross Margin = Revenue – COGS
For calculating the Gross Margin as percentage value:
Gross Margin % = Gross Margin / Revenue
Net profit, also referred to as the Bottom Line or Net Income, is calculated from the gross profit minus operating expenses, minus the cost of goods (COGS), and all other expenses. The latter include taxes and interest paid on debt. In other words, after paying all the working expenses, you are left with the final total amount of profit that a company made during a specific period.
How to calculate Net Profit
To calculate the Net Profit:
Net Profit = Revenue – COGS – Operating Expenses – Other Expenses – Interest – Taxes
For calculating Net Profit as a percentage value:
% of Net Profit Margin = Net Profit / Revenue
The calculation of these three metrics is beneficial to every stage of development of a SaaS company. In the early stages of a company’s growth, the operation and sales are not always as well-organized as we would want them to be. However, using these metrics to analyze your numbers is the right way to do things. Incidentally, do not forget to consider other metrics as well, but these 3 should always be at the top of your priority list.