In today’s economic climate where everything is a subscription or ‘as-a-service’ (e.g. SaaS), investors and executives often need a simple yet effective way to evaluate a company’s financial health. The Rule of 40 is one such metric, providing a snapshot that balances both growth and profitability.
The Rule of 40 is a financial guideline that combines a company’s revenue growth rate and its profit margin into a single number. The formula is straightforward:
Rule of 40 = Revenue Growth Rate (%) + Profit Margin (%)
- Revenue Growth Rate is typically measured on a year-over-year basis.
- Profit Margin is often calculated as EBITDA margin or free cash flow margin.
According to the Rule of 40, if the sum of a company’s growth rate and profit margin is 40% or higher, the company is generally considered financially healthy. This metric is especially valuable for SaaS businesses, which often face the challenge of balancing rapid growth with sustainable profitability.
One of the key benefits of the Rule of 40 is its flexibility. It recognises that high-growth companies may operate at a loss in the short term, while more mature companies may grow slowly but maintain strong profitability.
Example 1 – High Growth, Low Profitability:
- Revenue growth: 50%
- Profit margin: -10%
- Rule of 40: 50 + (-10) = 40 ✅
Even though the company is not yet profitable, its rapid growth keeps it within the healthy range.
Example 2 – Moderate Growth, High Profitability:
- Revenue growth: 20%
- Profit margin: 25%
- Rule of 40: 20 + 25 = 45 ✅
A slower-growing company can still be considered healthy if it demonstrates strong profitability.
Example 3 – Low Growth, Low Profitability:
- Revenue growth: 10%
- Profit margin: 15%
- Rule of 40: 10 + 15 = 25 ❌
This company would be underperforming, signaling potential issues with strategy, efficiency, or market fit.
Why the Rule of 40 Matters
The Rule of 40 has become a benchmark for investors and management teams alike. It allows stakeholders to quickly assess whether a SaaS company is striking the right balance between growth and profitability. Additionally, it informs strategic decision-making, helping leaders determine whether to prioritise accelerating growth or improving margins.
By using the Rule of 40, companies can make trade-offs with confidence. High growth can compensate for short-term losses, while strong profitability can offset slower expansion. This balanced perspective is particularly useful in the competitive SaaS landscape, where scaling quickly while maintaining financial discipline is often a delicate challenge.