Last week during my B2B masterclass HelloMeets session, the audience loved the SaaS metrics slide on the deck. We discussed metrics that every SaaS startup must track during the various stages of the product lifecycle. We also discussed company-wide metrics that the founders should track. The audience had some idea about most of the metrics mentioned on the deck sans SaaS Quick Ratio.
Here is an attempt to explain the Quick Ratio for SaaS businesses. Below is a list of all the topics we will cover in this blog. Go ahead and click on any of these links, and you’ll be taken to that specific section.
What is the SaaS Quick Ratio?
In accounting and finance, the quick ratio is a type of liquidity ratio, which measures a company’s ability to use its near cash or quick assets to pay for its current liabilities immediately.
The quick ratio is also known as the acid-test ratio. It is the measure of a company’s growth efficiency.
I learned about the Quick Ratio’s application to SaaS businesses when Social Capital VC Mamoon Hamid unveiled it at the SaaStr Convention in 2015. Since then, the SaaS Quick Ratio has become one of the investors’ standard fundraising asks.
The SaaS Quick Ratio helps investors judge how promising (or risky) their investment could be.
The SaaS Quick Ratio is defined as the ratio of revenue growth over a certain time-period vs revenue shrinkage in the same period.
SaaS Quick Ratio = (New MRR + Expansion MRR) / (Churned MRR + Contraction MRR)
Let’s understand the metrics that help us find the Quick Ratio:
- New MRR: Recurring revenue earned from new subscriptions in a given month.
For example, if a SaaS company with a plan of $10 user/month gets 20 customers with an average team size of 10 users, its new MRR for that month is $2000.
- Expansion MRR: Expansion in a SaaS business mostly happens when an existing customer upgrades to a higher plan or when the number of users increases. Higher the Expansion MRR the better.
For example, if a customer paying $200/month for 10 users till last month adds 5 more users from the current month, the Expansion MRR from that customer is $100.
- Churned MRR: Lost revenue from subscription cancellations in a given month.
For example, if a SaaS company with a plan of $10 user/month loses 5 customers with an average team size of 10 users, its churned MRR for that month is $500.
- Contraction MRR: Contraction in a SaaS business mostly happens when an existing customer downgrades to a lower plan or when the number of users decreases.
For example, if an existing customer (with 10 users) plans to downgrade from his current plan of $20/user/month to $10/user/month, the contraction MRR for that month from this customer is $100. Lower the better.
Independent of the sales model, every SaaS company has all the above cases of revenue growth and loss. The SaaS Quick Ratio of a company indicates a company’s growth reliability despite the losses.
Simply put, SaaS Quick Ratio = (Monthly Growth Rate + Churn Rate) / Churn Rate
When should you start measuring the Quick Ratio?
While measuring the Quick ratio, be careful to examine the result over different time periods. Quick ratio measured in the first 2-3 years of a business won’t help you access the growth efficiency right. It is only after 3 years when the love from early adopters becomes statistically normalized by customers who seek quality and timely delivery besides your product vision. Ideally, a business should measure and compare the SaaS quick ratio YoY.
What’s more important – Growth or Churn?
The answer is the Quick Ratio.
The Quick Ratio has become the investors’ decider metric because it reflects the potential of all the teams at a company. While the sales and the product team own the New MRR, the retention team or the customer success teams take care of the Expansion MRR, Contraction MRR, and churned MRR.
Let’s take an example of an early-stage SaaS business (EarlyStage SaaS Inc.) with an SMB focus, currently running at $2.4M ARR (~$200k MRR) and aiming to grow 50% heading into a new year.
To achieve this, they must add 50% x $2.4M = $1,200,000 of net new annually recurring revenue (ARR) over 12 months.
Assuming no-churn, the company would need to add $1.2M / 12 months = $100k of total new MRR (or $8,333 new MRR per month) to be on track to hit their growth target.
However, as an SMB focused offering with a typical 3% gross monthly churn (~31% annual churn), they will lose 3% x $200k = $6,000 of MRR in January of our example year, and so will need to add $6,000 of new revenue to make up for that and stay on pace for their growth target for the year.
So, they will need to acquire or upsell a total of $8,333 + $6,000 = $14,333 of new MRR in January.
Quick Ratio= $8333 + $6000$6000 = 2.4
Quick Ratio Calculator
Please try the spreadsheet-based Quick Ratio calculator, below.
What is an ideal quick ratio for a SaaS business?
Larger the quick ratio, the better. A company with a zero churn rate will have an infinite quick ratio.
A positive number means that a business is growing: that is, the amount of new revenue increases is larger than the amount of revenue lost. A negative number means a business is not doing well: the number of customers leaving is higher than the number of new customers gained.
Let’s look at startup benchmark data to find an optimal quick ratio for a SaaS startup. The table below summarizes churn rates across different types of SaaS products:
Mamoon Hamid, who introduced the SaaS Quick Ratio, says that a SaaS Quick Ratio of 4 or higher indicates a healthy-enough growth rate. A company with SaaS Quick Ratio more than 4 would be adding revenue 4x faster than it is losing it.
|Monthly Growth Rate||10%||15%||20%|
|Monthly Churn Possible||3.3%||5.0%||6.7%|
|Annual Revenue Loss||33%||46%||56%|
SaaS Quick Ratio of 4 or higher indicates a healthy-enough growth rate
If a startup growing at 15% aims to have a quick ratio of 4, it can sustain a monthly customer contraction & churn rate of 5.0% per month, or 46% annually. At a 20% monthly growth rate, a company can record a 6.7% monthly churn and still attain a quick ratio of 4.
How to use the SaaS Quick ratio?
The quick ratio can help you optimize your Marketing and Customer Success teams’ efforts. The chart below depicts how the Quick ratio changes with the change in growth and retention rates:
A high Quick Ratio can only be achieved if a product’s acquisition and retention teams are performing well. The location of a product’s growth and retention numbers (and hence quick ratio) in the above matrix helps understand the course correction measures. If a product has a high retention rate and low acquisition rate (top left), the marketing and sales teams need to improve the new MRR numbers. Similarly, if a product has a high acquisition rate and low retention rate, the customer success team needs to improve the churn numbers and find ways to retain a customer for as long as possible and increase the Lifetime Value (LTV).
I hope that you will start using Quick Ratio to monitor the growth of your SaaS product. If you’d like to discuss your numbers and their implications further, please submit your email and we will reach out to discuss. Alternatively, please contact us directly.