companies profit cash tech flow operating gross
Profitability Measures for Tech Companies###With the tech funding market’s shift in focus from revenue growth toprofitability as come a lot of confusion on which measure of profitability isa suitable benchmark for tech companies.#### Gross ProfitRevenue less costs directly associated with delivering that product/service.The costs are relatively straightforward for physical goods (ie the cost oforiginally purchasing the good and then delivering it to the customer) this isa little less clear for tech companies providing a service. The cost directlyassociated with the sale are then the allocated cost of the servers andinfrastructure as well as the full cost of support staff. Why its Important: Gross Profit is the single most important profitabilitymeasure for tech companies and gross profit margins (gross profit / revenue)should typically be above 50% for an eCommerce company and above 60% for Saasor digital media companies. Low gross margins businesses may still be viablebut they struggle to grow at the rates that VC’s or markets demand as they donot have enough residual margin to pay for a large sales effort.#### Contribution MarginThis 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 isno agreed upon standard. The only difference with gross profit margin is thatcontribution margin excludes fixed costs and so it will always be higher thangross margin. For tech companies this will typically be the depreciation ofthe hardware (usually servers) which delivers the service. Depreciation isessentially the apportioned cost of hardware required to deliver the serviceand ignoring it gives a distorted view of profitability.#### Operating ProfitGross Profit less expensing incurred in normal business operations such assales, marketing and admin expenses. Few tech companies under 10 years of agegenerate any meaningful operating profits. Marketplaces and digital mediacompanies tend to run at around operating profit break-even. Saas companiesusually run around -15% operating profit margins since Saas revenues don’treflect the lifetime values of their customers.#### Net ProfitOperating profit less non-operating expenses sure as interest payments, one-off charges and tax. Typically for tech companies this is similar to operating profit.#### Cash FlowAll profits should eventually manifest as cashflow (that there is a differentat all is primarily due to accounts being prepared under the accruals conceptwhich allows companies to recognize revenues when they are ‘earned’ but notpaid). The two most useful measures of cash flow are Operating Cash Flow which is thecash generated from ongoing business operations and Free Cash Flow which isOperating Cash Flow plus capital expenditure. For tech companies Free CashFlow is the more relevant measure as capital expenditure (primary on hardwaresuch as servers) should usually be considered necessary ongoing expenditure.High negative free cash flow relative to revenues or to cash balance are awarning signal and cannot be sustained for long periods.It should be noted that many public tech companies (notably Twitter) operateat cash flow break-even but record large net profit loses. The core reason forthis is the accounting requirement to expense employee stock option grantswhich reduces profits but has no impact on cash flow since option grantsinvolve no cash outflow.#### EBITDA/EBIT/Adjusted EarningsThese are all ad-hoc measures created by companies which claim to give a truerpicture of their profitability and should all be treated with extreme caution.There can be significant insight gained from adjusting GAAP accountingearnings — in Saas businesses for example revenue could expanded to accountfor some of the customer’s lifetime value. However, this should be doneconservatively and consistently applied across different companies. Relying on companies’ own measures of adjusted earnings is fraught with dangeras there is no common definition for the measures and companies often cherry-pick which items to exclude to flatter their earnings.