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The whole point of starting and growing a business is to return value to its shareholders. And it doesn’t matter if it’s a one-person SaaS company or a large multinational SaaS firm. All companies, at some point, want to make money and earn profits.
For SaaS companies, however, with no inventory and an agile business structure, measuring profitability is unique.
We’ve therefore outlined the top SaaS financial metrics that accurately measure a company’s profitability. The ratios are used to determine how well a business is performing and how it can perform even better.
Read about the following ratios below and then begin implementing them in your SaaS business today.
Pure Profit Margin Ratios
The most important - and easiest - SaaS financial metrics to understand are the three profitability ratios. These metrics are called “pure ratios” because they use numbers from only one financial statement: the statement of income.
Learning how to track and analyze these three measures of profitability will help your SaaS business with its price point, cost of goods sold, operational efficiency, and with its overall structure.
1. Gross Profit Margin
This is the first SaaS financial metric that measures profitability and the first that you can derive. Literally. Gross profit is considered a top line profitability number because it uses the first two traditional numbers on a company’s statement of income.
The ratio is meant to measure the percentage earned on the sale of a product or service, after taking into account the supplies and materials that went into producing the product or service.
Gross profit margin is derived as:
(Gross profit) / (Total revenues)
Gross profit, of course, is the number of sales you earn over a period of time after subtracting the associated cost of goods sold (COGS). So, if you sell USD $10,000 worth of a SaaS product and your COGS is $2,000 total for that time period, your gross profit would be (USD $10,000 - USD $2,000) = USD $8,000.
Then, to find your gross profit margin, you’d take USD $8,000 and divide it by your sales of USD $10,000 over that period to get a margin of: (USD $8,000) / (USD $10,000) = 80 percent. Not bad at all!
Gross profit margin is a good profitability measure because it can show you if you’re paying too much for your goods and services or if you’re charging too little for your product.
2. Operating Profit Margin
Operating profit margin is next, mainly because it includes more expenses when calculating the profitability of a SaaS company. Specifically, this margin factors in all operating expenses and general overhead. The result is a SaaS financial metric that shows you how well your company’s operating.
While gross profit margin only recognizes COGS in its measure, operating profit margin takes a much larger picture at a company. The financial metric is derived as:
(Operating profit) / (Total revenues)
It starts with operating profit, which is the total amount of dollars a company earns after factoring in all COGS and operating expenses. So, operating profit would be derived as: (sales) - (COGS) - (Operating Expenses). It’s essentially the money your company has in the bank after all normal business expenses have been paid.
From there, you can calculate operating profit margin by taking your operating profit and dividing it by total sales. If you have operating expenses of USD $6,000, for example, with sales of USD $10,000 and COGS of USD $2,000, your operating profit margin would be: (USD $2,000) / (USD $10,000) = 20 percent. Again, not bad!
Operating profit margin measures how well your SaaS company is operating because it takes into account all salaries and wages, server costs, office expenses, general and administrative expenses, and more.
3. Net Profit Margin
Net profit margin is the most common type of profitability measure. It’s the ultimate test to see if your company is making money or not. It’s therefore the most important because it takes into account every expense your business makes, including taxes and interest payments.
It’s considered a company’s “bottom line” because it uses the last number on the statement of income in the numerator: Profit. Net profit margin is therefore derived as:
(Total Profit) / (Total Revenue)
Operating profit is calculated by taking gross profit and subtracting all operating expenses. Total profit is calculated by taking operating profit and subtracting any taxes, interest payments, and other non-operating expenses.
So, if your company’s operating profit is USD $2,000 and you pay USD $1,000 in taxes for that period, your total profit would be: (USD $2,000) - (USD $1,000) = USD $1,000. You would then find your profit margin by taking USD $1,000 and dividing it by the USD $10,000 you made in sales to get: (USD $1,000) / (USD $10,000) = 10 percent.
Net profit margin is important because it represents the percentage revenue you get to keep in your bank after all expenses have been paid. So, if you have a 10 percent profit margin, it means that for every USD $1.00 you make in sales, your company earns USD $0.10.
Importance of SaaS Financial Metrics for Profitability
A profitable business is a healthy business. With increasing profits, SaaS companies can borrow money, attract investors, or bootstrap to fuel their own growth.
The more profitable a SaaS business is, the better chance it has of achieving and maintaining success. Even if the end-game is to become acquired by a larger company, the best way to do it is by running a profitable business.
So, when you review your company’s financial statements, first look at your three historical profitability ratios. This will give you a baseline to measure the future performance of your company. You’ll want to check your annual profit growth as well as your month-over-month profit growth for each of the three measures.
Then, sit down with your team and come up with profit goals for each ratio. For example, if your company has historical net profit margin growth of 5 percent each month, set a stretch goal of a 10 percent monthly profit margin growth. If your business operates with a 20 percent operating profit margin, see if you can cut expenses and increase it to 25 percent.
Reviewing your historical numbers and setting new goals ensures that your entire business is running efficiently, from top to bottom.
Note: At Quaderno we love providing helpful information and best practices about taxes, but we are not certified tax advisors. For further help, or if you are ever in doubt, please consult a professional tax advisor or the Tax Agency.