Profitability Measures for Tech Companies
With the tech funding market’s shift in focus from revenue growth to profitability as come a lot of confusion on which measure of profitability is a suitable benchmark for tech companies.
Revenue less costs directly associated with delivering that product/service. The costs are relatively straightforward for physical goods (ie the cost of originally purchasing the good and then delivering it to the customer) this is a little less clear for tech companies providing a service. The cost directly associated with the sale are then the allocated cost of the servers and infrastructure as well as the full cost of support staff.
Why its Important: Gross Profit is the single most important profitability measure for tech companies and gross profit margins (gross profit / revenue) should typically be above 50% for an eCommerce company and above 60% for Saas or digital media companies. Low gross margins businesses may still be viable but they struggle to grow at the rates that VC’s or markets demand as they do not have enough residual margin to pay for a large sales effort.
This is not found on an Income Statement and should be treated with caution. The contribution margin is revenue less variable costs divided by revenue, although the precise definition varies from company to company since there is no agreed upon standard. The only difference with gross profit margin is that contribution margin excludes fixed costs and so it will always be higher than gross margin. For tech companies this will typically be the depreciation of the hardware (usually servers) which delivers the service. Depreciation is essentially the apportioned cost of hardware required to deliver the service and ignoring it gives a distorted view of profitability.
Gross Profit less expensing incurred in normal business operations such as sales, marketing and admin expenses. Few tech companies under 10 years of age generate any meaningful operating profits. Marketplaces and digital media companies tend to run at around operating profit break-even. Saas companies usually run around -15% operating profit margins since Saas revenues don’t reflect the lifetime values of their customers.
Operating profit less non-operating expenses sure as interest payments, one-off charges and tax.
Typically for tech companies this is similar to operating profit.
All profits should eventually manifest as cashflow (that there is a different at all is primarily due to accounts being prepared under the accruals concept which allows companies to recognize revenues when they are ‘earned’ but not paid).
The two most useful measures of cash flow are Operating Cash Flow which is the cash generated from ongoing business operations and Free Cash Flow which is Operating Cash Flow plus capital expenditure. For tech companies Free Cash Flow is the more relevant measure as capital expenditure (primary on hardware such as servers) should usually be considered necessary ongoing expenditure.
High negative free cash flow relative to revenues or to cash balance are a warning signal and cannot be sustained for long periods.
It should be noted that many public tech companies (notably Twitter) operate at cash flow break-even but record large net profit loses. The core reason for this is the accounting requirement to expense employee stock option grants which reduces profits but has no impact on cash flow since option grants involve no cash outflow.
These are all ad-hoc measures created by companies which claim to give a truer picture of their profitability and should all be treated with extreme caution. There can be significant insight gained from adjusting GAAP accounting earnings — in Saas businesses for example revenue could expanded to account for some of the customer’s lifetime value. However, this should be done conservatively and consistently applied across different companies.
Relying on companies’ own measures of adjusted earnings is fraught with danger as there is no common definition for the measures and companies often cherry-pick which items to exclude to flatter their earnings.