ruly Rule of 40: growth and FCF margin for software companies
What the rule of 40 measures (revenue growth plus FCF margin), how to calculate it from an annual report, its thresholds, its traps and the sectors where it does not apply.
Published
Definition
The rule of 40 adds revenue growth to the free cash flow margin (FCF divided by revenue). It assesses the balance between growth and profitability: a company can sacrifice its margin to grow fast, or grow slowly with a high margin. The sum of the two sums up both options in a single figure.
Formula
Rule of 40 = annual revenue growth (%) + FCF / revenue (%)
Where to find it in an annual report
Revenue growth is calculated from the income statements of two consecutive financial years. FCF is calculated from the cash flow statement: operating cash flow minus capital spending. Some software companies publish their own FCF margin in the management report.
Common thresholds
Reasonable growth: 40% or more for green, 25 to 40% for orange, red below. The 40% benchmark comes from investor practice in subscription software. Some use the EBITDA margin instead of the FCF margin, which gives higher figures.
In the preset strategies
| Preset strategy | Criterion met | To monitor | Criterion not met |
|---|---|---|---|
| Reasonable growth (calculated) Revenue growth + FCF margin | ≥ 40% | 25% to 40% | < 25% |
Pitfalls
- The rule ignores dilution: a flattering FCF margin can rest on stock-based pay, which does not come out of cash.
- Growth achieved through acquisitions inflates the total without saying whether the original business is growing.
- A single year can mislead: a large contract paid in advance makes that year’s FCF margin jump.
- Comparing companies that do not use the same margin (FCF, EBITDA, operating profit) makes no sense.
Where it does not apply
- Industry, retail, energy: their margins and investment needs put the 40% threshold out of reach without the company being fragile.
- Banks, insurers and real estate companies: FCF does not mean the same thing there.
A worked example
A fictitious software company, called Company J here, sees its revenue grow from €160 million to €200 million, a growth of 25%. Its FCF is €30 million, an FCF margin of 30 / 200 = 15%. Its rule of 40 gives 25 + 15 = 40%: it just reaches green.
Why a sum
A company growing at 50% can lose money for a while without cause for concern, if its growth brings closer the point where its fixed costs are covered. Another growing at 5% needs an FCF margin of 35% to reach the same total. The sum puts both profiles on the same scale. See also the revenue growth entry.
Sources
- Annual reports of listed companies (income statement, cash flow statement)