“Our margin is way too low — that’s definitely something we need to work on this year.”
Just last week, we were speaking with an SaaS client, and this was what they told us. Upon asking them what they meant, the client clarified that they wanted to increase their gross margin — but beyond that, they weren’t sure how high their margin should be, or how improving this margin would impact their business.
Now, we find that this is a common occurrence– while many SaaS business owners keep track of their numbers, they don’t fully grasp their meaning and implications. To remedy this, we’ve put together this article that you can use to demystify your SaaS P&L once and for all.
First and foremost, the P&L statement is one of the three basic financial statements that every company maintains (the other two being: your cash flow statement and balance sheet). The P&L allows you to have an overview of your revenue, costs and profit over a period of time, and it provides you with a foundation that you can use to guide your business decisions and strategy.
That said, note that your P&L statement doesn’t paint a full picture of your SaaS financials. In order to conduct a full evaluation, you’ll have to look at other key metrics as well. Check out these 8 SaaS specific metrics that every SaaS business should keep track of.
The key part of your SaaS P&L is your revenue, which is the total amount of income generated by your company. When it comes to recording your revenue, you can choose to utilize either a cash or accrual accounting method. With cash accounting, you report revenue as and when the cash enters your hands (or your bank account). With accrual accounting, you record your revenue when it’s earned, regardless of whether you’ve actually received the payment for your goods and services.
As a general rule of thumb, companies should always use the accrual accounting method. This gives business owners or finance teams a more realistic picture of a company’s income and expenses over a period of time; it also allows you to keep track of the company’s profitability more accurately.
Also relevant here is Monthly Recurring Revenue (MRR); this deals with the recurring revenue that SaaS companies get from the subscription model that they employ. If your company deals exclusively in SaaS products, and you don’t earn any consulting fees or other revenue, then your revenue is equivalent to your MRR.
Cost of Sales
Next, when looking at your SaaS P&L,you’ll also have to factor in your Cost Of Sales. These are the costs that you make to service your existing customers. These include hosting costs, payment charges, commissions that you pay out to your sales reps or affiliates, and costs of hiring a customer support team. Seeing as you’re operating a SaaS company, you don’t have any Cost Of Goods Sold (COGS) to contend with; that said, you still incur costs in serving your clients.
To identify your Gross Margin, just subtract your Cost of Sales from your Revenue. This represents the earnings that you get from delivering your service, and it’s arguably the most important metric in your P&L.
If you’re working with a small team where the management team takes on multiple hats (including, say, responding to customer inquiries from time to time), then this makes calculating an accurate gross margin difficult. For SaaS businesses who are having trouble with this, you might want to enlist Insight Matters who has experience in estimating Cost of Sales and Gross Margins.
Good to note: the median gross margin for SaaS businesses ranges from 75 to 80%, so if your gross margin is higher than this, it means that you have more flexibility when it comes to your Customer Acquisition Costs (CAC). In other words: because you’re earning a sizeable amount from each customer that you bring on board, you can spend more to acquire new customers!
SG&A refers to the Selling, General &Administrative Expenses that you report on your income statement. We tend to divvy up SG&A into four key categories — marketing, sales, development and overheads. Depending on your business, you could refine and subdivide the categories further to get more detailed insight in your costs.
Another important element of your SaaS P&Lis your EBITDA, which stands for Earnings Before Interest, Tax, Depreciation and Amortization. To calculate EBITDA, subtract your SG&A from your gross margin. You can take this to be the main indicator of your operating efficiency, and for those of you who are looking to sell your business in the future, EBITDA is also widely used as the basis for valuations (next to revenue multiples).
Note that in the early stages of your growth,your EBITDA may be negative. That’s fine, as long as your gross margin is high enough.
Net profit / Net income
Finally, we have Net profit or Net income (the two terms are interchangeable, just to be clear). This is pretty straightforward; once you deduct your depreciation, amortization, and interest costs from EBITDA, you’ll get your Earnings Before Taxes (EBT). Subtract your taxes from here, and this gives you your Net profit.
Improving your SaaS profitability
Here’s the million-dollar question: which part of your SaaS P&L should you focus your efforts on? A good rule of thumb is to try and increase your gross margin; you can do this in two ways — either increase your revenue or decrease your Cost of Sales.
Now, any business owner will understand the importance of keeping your costs under control; that said, cutting costs will only bring you so far. If you want to increase your profits by 5x, 10x, or 20x, it’s unrealistic to achieve that via cutting costs — it’ll be much easier to do this by increasing your revenue instead.
I’m sure you’ve heard of a vicious circle, well, this is the exact opposite — it’s a virtuous circle that you want to be part of. Once you achieve a higher gross margin, you can afford to spend more on your CAC. This brings you more clients, which in turn reduces your Cost of Sales, and this brings you full circle and increases your gross margin once again.
A final word on working out your SaaS P&L
All the financial jargon can be overwhelming, so make sure you use this guide to help you navigate your SaaS P&L, and identify the areas that you want to focus on.
If you don’t have a dedicated CFO or finance team, consider working with Insight Matters to understand and improve your numbers. At the end of the day, if you’re struggling with your finances, you won’t have the time to strategize and plan for your company’s growth. Once you’ve got your finances in check, though, you’ll be maximizing your company’s potential, and taking it to the next level.