Definition

The Rule of 40 states that the combined value of growth rate and profit margin of healthy Saas companies should be above 40%. Saas companies who are able to move above 40% are earning profits at a sustainable rate whereas companies under 40% may have cash flow difficulties or liquidity issues.

Example

To calculate Rule of 40, a company must add its growth rate and profit margins.The formula is SaaS rule of 40 = Growth Rate % + Profit Margin %. Suppose a company's profit margin is 25% and it achieves a sales growth rate of 16%. The rule of 40 will therefore be 41. This is a positive sign for the business. However, if this value drops to 35 then the company may have to work towards attracting more investors and protecting shareholder wealth.

Why it matters

The rule of 40 acts as a benchmark for companies to compare their performance against another. It helps achieve the right balance between growth and profitability. Overall, businesses can take well-informed decisions with the help of this metric.

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