How to Calculate and Use the Rule of 40 in Business

When evaluating the financial health of a company, it's crucial to consider various metrics that provide a comprehensive view of its performance. One such metric is the Rule of 40, which combines growth and profitability factors to assess a company's overall health. It is mainly used for SaaS (Software as a Service) companies given their emphasis on growth, but can be relevant for other types of business as well. In this guide, we'll explore what the Rule of 40 is, why it's important, and how to calculate it.

What is the Rule of 40?

The Rule of 40 principle is a financial metric used to measure the balance between a company's revenue growth and profitability. It helps investors and business owners assess whether a company is achieving a healthy equilibrium between expansion and financial stability. The Rule of 40 formula is as follows:

Rule of 40= Revenue Growth Rate + EBITDA Margin

Why is the Rule of 40 Important?

The Rule of 40 is important for several reasons:

1. Balanced Growth: It ensures that a company's growth rate is sustainable and doesn't come at the expense of profitability.
2. Investor Confidence: Investors often use the Rule of 40 to identify companies that are well-positioned for long-term success. A positive Rule of 40 indicates a healthy balance between growth and profitability, instilling confidence in investors.
3. Comparative Analysis: It facilitates the comparison of companies across industries by providing a standardized metric that considers both growth and profitability.

How to Calculate the Rule of 40

Before calculating the Rule of 40, you need the following information:

• Revenue Growth Rate: Calculate the percentage change in revenue over a specified period.
• EBITDA Margin: Determine the EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) margin, which is the ratio of EBITDA to total revenue.

Then you apply the formula: 

Rule of 40= Revenue Growth Rate + EBITDA Margin

Finally, you interpret the results. The Rule of 40 states that a company’s combined growth rate and profitability margin should be at least 40%. 

• A positive Rule of 40 (e.g., 30% growth rate + 15% EBITDA margin = 45%) generally indicates a healthy balance between growth and profitability.
• A negative Rule of 40 (less than 40%) may suggest that the company is either growing too fast at the expense of profitability or experiencing low growth with high profitability.

The following example illustrates how to calculate the magic Rule of 40 for a hypothetical company:

• The Revenue Growth Rate output is seen in cell G3, and the formula in G4. 
• The EBITDA Margin for each year is calculated in cells C6 and D6, and  the formulas in C7 and D7. For the Rule of 40 calculation we are interested in the latest EBITDA Margin (year 2023)
• The Rule of 40 output is in cell C9, and the formula in C10. It is the sum of the Revenue Growth Rate of cell G3 and the EBITDA Margin of cell D6.

Considerations and Best Practices

1. Consistency is Key: Use consistent timeframes and methodologies when calculating the Rule of 40 for accurate comparisons.
2. Industry Benchmarking: Compare your Rule of 40 results with industry benchmarks to assess your company's standing relative to peers.
3. Long-Term Perspective: Evaluate the Rule of 40 over multiple periods to identify trends and assess the company's ability to maintain a healthy balance over time.

While the Rule of 40 provides valuable insights into a company's financial health, it's essential to use it together with other metrics for a comprehensive analysis. Understanding the interplay between growth and profitability is key to making informed decisions about investments, partnerships, and the overall strategic direction of a business.