Read TL;DR
- EBITDA is a crucial SaaS metric that helps operators and investors understand how well a SaaS company can generate cash flow from recurring revenue streams. EBITDA and EBITDA margins are often used to evaluate the financial stability of a company.
- It is impacted by internal factors such as pricing strategies, pace of customer acquisition, and operating expenses and external factors such as inflation, rising costs of inputs, and lower purchasing power.
- Formula: EBITDA = Revenue - COGS - OpEx or EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) is a key metric for SaaS business leaders because it helps them understand the efficiency of their operations without the “noise” of their financial structure and tax strategies.
EBITDA is a profitability metric used to gain insights into a company's operational and financial performance. By leaving out non-operational expenses – interest, taxes, depreciation, and amortization – the earnings information in EBITDA provides a clear picture of a company's ability to generate cash flow from its core business activities. While widely used in SaaS, EBITDA is considered a non-standard measure of profitability as it is not recognized under the Generally Accepted Accounting Principles (GAAP) in the United States.
Because EBITDA focuses on earnings from recurring revenue through subscriptions and/or service contracts, it also offers a useful snapshot of profitability for investors drawn to SaaS companies based on the long-term customer relationships and steady revenue that characterize the SaaS business model.
This article discusses the significance of EBITDA for SaaS companies including its role in SaaS valuations, and some important nuances of the metric. You’ll also learn how it’s calculated and how technology can make EBITDA calculation and reporting easier.
Table of Contents
Understanding the importance of EBITDA in SaaS
EBITDA is not just a number. It provides a lens into your business's financial health and operational efficiency. In SaaS, where recurring revenue streams are favored over one-time sales, EBITDA is essential for assessing profitability.
A steady or growing EBITDA margin of a company signals good financial health. A higher EBITDA margin signifies a lower-risk, financially stable company with fewer operating costs and strong earnings potential.
Factors impacting EBITDA
EBITDA is impacted by factors both within (internal) and beyond (external) a company’s control:
- Internal factors: Internal factors are elements that you can control and manage to strengthen your company’s EBITDA. For example, you can boost revenue by acquiring new customers, upselling, or modifying pricing strategies. You can also work to better manage operational expenses or lower costs, such as reducing overhead or optimizing spending.
- External factors: External factors are harder to manage and outside your control but still affect EBITDA. These can include a variety of factors such as inflation, which can increase costs and purchasing power, or changes in demand, prices, or customer preferences that can add to operational costs. Other factors include increased competition which pushes companies to lower prices and reduce revenue or new/changing regulations that can affect operations and increase costs.
Learn more about SaaS metrics here
How to calculate EBITDA for a SaaS business?
EBITDA is a line item on the income statement. Calculating EBITDA is relatively straightforward and uses GAAP-compliant numbers. It can be calculated in a couple different ways.
Method 1: The EBITDA formula
The standard formula for calculating EBITDA is:
With this formula, you start with your company’s net income (total earnings or losses), add any interest expenses on debt, and then factor in taxes (such as corporate income tax). Finally, include depreciation for tangible assets (like computers and other equipment) and amortization expenses for intangible assets (such as software you own, trademarks, etc.).
There are a few considerations though:
- Net income is total earnings or losses, which can be found at the bottom of your income statement (aka P&L statement).
- Interest is the cost of borrowing funds and does not include interest income.
- Taxes refer to income taxes only, not sales taxes.
- Depreciation accounts for wear and tear on tangible assets. While the assets are tangible, depreciation is a non-cash expense.
- Amortization spreads the cost of intangible assets over a period of time. Such assets (e.g. patents) are amortized because they typically have a limited useful life.
Let’s look at an example calculation of EBITDA using the formula above. We’ll assume that SaaS Company XYZ has a net income of $2,000,000 for the year. Over the course of the same year, it paid $100,000 in interest expenses, $250,000 in taxes, and $500,000 in depreciation and another $300,000 in amortization expenses.
Applying the above formula, the EBITDA for our example company would be calculated as follows:
This calculation provides a rough estimate of Company XYZ’s operating cash flow before considering capital expenditures, changes in working capital, or other non-operating expenses.
Method 2: Simplified EBITDA calculation
The formula below is the easiest way to calculate EBITDA:
Where:
- Revenue is the total income from sales.
- COGS represents the total cost of goods sold, which includes costs for your SaaS services like hosting, software license, server and cloud storage, and website maintenance fees.
- OpEx includes operating expenses such as sales, marketing, research and development (R&D) and general and administrative (G&A) expenses.
Regardless of how you calculate EBITDA, it's important to note that it is not a perfect measure of a company's financial health because it doesn’t account for all expenses or consider the company's debt and capital structure. Due to these limitations, it’s best to consider EBITDA with other financial metrics to comprehensively understand a SaaS company’s performance.
Advantages and limitations of the EBITDA metric
EBITDA is a common benchmark and quite useful metric for assessing a company’s financial health but it does come with some caveats. While EBITDA allows investors to compare companies' performance based on core operations, because it does not account for the cost of debt, tax obligations, or capital expenditures, it can be misleading if not well understood. Here are a few more things you need to consider when evaluating a SaaS company's EBITDA.
Advantages of tracking EBITDA
- Provides business clarity: EBITDA provides a clear view of a SaaS company’s financial and operating health based on business activities without the effects of financing, tax, and accounting.
- Is regarded as a benchmarking KPI: The widespread use of EBITDA makes it a valuable operational KPI for comparing profits with others in the same industry.
- Ensures investor appeal: Lenders use EBITDA to see if a company can pay off debts, while investors assess it to judge profitability and investment potential.
Limitations of EBITDA
- Doesn’t include cash flow: EBITDA gives an incomplete financial picture as it does not include important cash activities, like daily expenses (working capital) and major purchases (capital expenditures).
- Provides a partial financial picture: A high EBITDA might make a company appear more profitable than it is. It doesn't include major costs like depreciation or interest, which could hide underlying financial issues.
- Is seen as a non-GAAP standard: Since EBITDA isn't recognized under GAAP in the United States, it doesn't appear on income statements. This means there's no standard way of calculating and reporting it.
SaaS valuation and EBITDA
Investors use EBITDA and EBITDA margins to evaluate companies without the distraction of interest, taxes, or non-cash costs like depreciation because the evaluation is based on real earnings from business operations.
The EBITDA margin measures a company’s operating profit as a percentage of its revenue to provide a normalized value for fair comparison. The EBITDA margin is calculated using the following formula:
EBITDA margins in the SaaS industry depend on various factors like company size, growth stage, and cost structure.
A fair evaluation of EBITDA of SaaS companies can be done by considering:
- Current performance: Assessment of the company's management of revenue and costs. A strong EBITDA margin shows control over expenses and suggests efficient operations.
- Projection of future performance: Investors look for the ability to maintain or grow EBITDA margins as the company scales. High margins along with a realistic growth plan can increase a company's value.
- Market trends: Industry trends, like demand for specific SaaS solutions or general economic conditions, can affect valuations. Companies with high EBITDA margins will have higher valuations if there's strong market demand or growth in a niche, e.g., AI-driven SaaS tools.
Startups often aim for higher EBITDA margins as they mature to improve their financial stability and appeal to investors.
The EBITDA multiple
The EBITDA multiple is a financial ratio that compares a company’s enterprise value to its annual EBITDA (either a historical figure or a forecast/estimate). It is often used to determine the value of a company and compare it to the value of other similar businesses.
To calculate the EBITDA multiple, you have to first determine the enterprise value (EV) for the company. The EV represents the total value of the business, including its equity, debt, and cash, all of which can impact the actual cost of acquiring the company.
The EV is calculated using the formula below:
Once the EV is determined, that number can be plugged into the following formula to calculate the EBITDA multiple:
EBITDA vs. ARR
EBITDA and ARR are key metrics that contribute to a SaaS company’s valuation. They serve different roles.
ARR represents the predictable annual revenue from subscriptions, essential for assessing growth potential and revenue stability in SaaS businesses. Investors and SaaS leaders use ARR to understand how effectively a company is building its customer base and sustaining revenue.
In contrast, EBITDA measures profitability by focusing on operating earnings before expenses. It shows how well a SaaS company manages its core income. Both metrics are important, and the choice of emphasis depends on the company’s stage and whether investors focus on growth or profit.
EBITDA vs. the Rule of 40
EBITDA and the Rule of 40 are metrics that evaluate a SaaS company based on different aspects of business performance.
The Rule of 40, popularized by Brad Feld, states that a SaaS company’s revenue growth rate added to its profit margin should equal or exceed 40%. It is suitable for growth-stage SaaS businesses as it balances growth and profitability to assess financial health and investor appeal.
EBITDA is the profit metric in the Rule of 40 calculation.
EBITDA vs. Revenue
Revenue is the total income a company earns from its services. It shows the company’s sales success and growth potential. However, it doesn’t express a company’s profitability or operating efficiency.
EBITDA, in contrast, helps assess the SaaS company’s ability to control costs and achieve sustainable profitability.
Drivetrain makes calculating EBITDA and other key SaaS valuation metrics fast and easy
EBITDA offers insight into the financial performance of SaaS companies. It provides investors and lenders the confidence that the company will be able to generate cash and sustain operations.
SaaS financial planning and analysis (FP&A) solutions help finance leaders track the company’s performance and make the right, data-backed decisions to facilitate valuation. Accurate and GAAP-aligned numbers, validated by financial reporting tools, help calculate your SaaS business’ EBITDA more effectively.
Drivetrain, a strategic, third-generation FP&A platform, enables SaaS CXOs and finance teams track and manage business performance and make more informed strategic decisions, by:
- Automating data consolidation and integration: With over 200 integrations, Drivetrain seamlessly integrates with disparate business systems like HRIS, CRMs, and ERPs, to consolidate financial data, such as subscription revenue, operational expenses, and employee costs, without manual interventions. Centralizing data reduces the time and effort to calculate EBITDA and improves accuracy.
- Enabling regular financial reporting: Drivetrain generates timely and accurate financial reports for calculating EBITDA in real time. It saves the time and effort required to compile data from multiple sources manually. Regular reporting at scheduled intervals ensures all stakeholders can better track the company’s financial performance.
- Providing dynamic dashboards and analytics: Drivetrain provides intuitive dashboards to display key financial metrics visually. These dashboards help SaaS leaders quickly analyze financial data, track performance trends, and identify potential issues. The actionable analytics help companies make informed adjustments to improve their EBITDA.
- Benchmarking and tracking KPIs: Drivetrain offers advanced analytical tools to help SaaS leaders track performance and benchmark against industry standards. By tracking these metrics, SaaS companies can assess financial health, identify improvement areas, and set realistic goals to enhance profitability.
- Forecasting and planning: Drivetrain’s forecasting tools enable SaaS companies to project future revenues and expenses using historical data and market trends. Accurate forecasting ensures effective resource management and proactive financial decisions for addressing potential challenges.
Learn more about how Drivetrain can assist finance teams to better track, measure, and calculate EBITDA and improve financial performance.
FAQs
According to the Rule of 40, a company's revenue growth rate plus its EBITDA margin should equal or exceed 40% to be considered healthy. A SaaS company can remain healthy with low or negative profits if its growth rate compensates. Conversely, a slow-growing SaaS company with high profits can also show stability.
EBITDA focuses on operational profitability by excluding interest, taxes, depreciation, and amortization. It is useful for assessing a business's cash-generating ability from core operations. Net Profit, a GAAP-aligned figure, provides a comprehensive view of profitability by accounting for all business costs.
A good EBITDA percentage for a SaaS company is at least 40 percent minus the company’s MRR growth rate. For example, if a SaaS company has an MRR growth rate of 25 percent, a good EBITDA margin would be 15 percent or more.
EBITDA stands for “earnings before interest, taxes, depreciation, and amortization”. It is a profitability metric used to gain insights into a company's operational and financial performance. By leaving out non-operational expenses, the earnings information in EBITDA provides a clear picture of a company's ability to generate cash flow from its core business activities.
The EBITDA margin is EBITDA expressed as a percentage. This proves a normalized value useful for comparing the operational and financial performance of different companies. EBITDA margins are also widely used for benchmarking.
