SaaS companies are unique creatures in the business world.
While some companies rely on large transactions to drive company revenue, SaaS companies are a different animal. SaaS success is based on a large number of smaller transactions and recurring revenue through subscriptions or continued service to stay afloat.
That alone can make it more difficult to measure performance, as you need to look at more information surrounding the where and why of successful transactions, like churn rate, seasonality, upgrades and downgrades, and more.
Enter the SaaS quick ratio, the metric that’s supposed to help you effectively measure your SaaS company’s growth in an easily-digestible calculation.
Like Bard the Bowman taking down Smaug in The Hobbit, the SaaS quick ratio is supposed to expose company weak spots (through churn) clearly for everyone to see.
While the SaaS quick ratio is one of those metrics that could be mistaken for a vanity metric at first, it makes more sense when you think about the different ways you can apply the calculation to measure the success of your service offerings.
But before we get into that, let’s start with introducing the concept of the SaaS quick ratio.
Introduction to SaaS Quick Ratio
If you run a SaaS business or at least have some stake in its finances, you’ll want to know about the SaaS quick ratio. The ability to measure your company’s growth is rooted in a bunch of useful metrics, with SaaS quick ratio being one of them.
Don’t confuse it with the finance quick ratio, which is another metric that measures the immediate liquid assets a company has available to use towards liabilities.
What is a SaaS Quick Ratio?
The well-known venture capitalist Mamoon Hamid is credited with devising the SaaS quick ratio as a way of quickly measuring the health (revenue growth) of your SaaS business at a high level.
Hamid came up with the idea for the ratio by taking the quick ratio formula from accounting, also commonly known as the acid-test ratio, and adapting it to work with SaaS companies. The acid-test ratio is just one of many ratios that accountants use to determine a company’s financial stability and capacity to pay its current liabilities like taxes or payables and debts.
Since Hamid created the SaaS quick ratio, multiple venture capitalists, investors, and tech-savvy business people hold the ratio in high regard, and have been using it to measure the performance of SaaS startups and established SaaS companies alike.
The idea behind co-opting the accounting metric to SaaS growth is that it can give investors a better look into the overall health of a SaaS company with just one metric: it shows overall performance, but considers underlying churn as part of that overall performance.
While not a completely perfect way to measure the growth of your Saas company for reasons we’ll get into later in this article, the SaaS quick ratio is still widely regarded as a good benchmark for SaaS company performance.
Why is Saas Quick Ratio Important?
High churn rate bad. Low churn rate good.
This is the case for all companies, but especially SaaS, since they are known for being more volatile in general. If you’re hemorrhaging customers faster than you can obtain them, then your business is like a sinking ship with more holes than you can plug — it’s going to eventually go down, no matter how much you bail out water.
But it can be easy to get caught up in the day to day, especially with a SaaS startup, and forget to pay close attention to the numbers behind revenue.
It’s also an easy metric to pull out and show stakeholders and investors (aka. Your Boss) when they randomly ask you high-level questions, like how the company is doing (you can have that one for free).
It’s also normal for a company’s SaaS quick ratio to change over time, so that shoule be factored in as well. After all, countless things can affect MRR, including seasonality, upgrades and downgrades, and more, so it’s important that the ratio is calculated on a regular basis. Your quick ratio will also naturally change as your company reaches different growth stages.
One disclaimer though, is that the SaaS quick ratio shouldn’t be exclusively what you look at, nor should it replace other SaaS metrics that you use to keep a finger on company growth.
Instead, include the SaaS quick ratio as a regular line in your SaaS reporting documents.
A Quick Note About SaaS Magic Number and Rule of 40
The SaaS magic number and Rule of 40 is often discussed when referencing SaaS Quick Ratio, as these two metrics also measure growth rate efficiency, but in different ways.
SaaS Magic Number
The SaaS magic number measures sales efficiency through the money spent on sales and marketing. In other words, for every dollar you spend on marketing, how does that translate into company revenue?
Calculating your SaaS magic number is relatively simple; take your current ARR for a business quarter or MRR if you want to do a monthly calculation, and subtract that from the metric from the prior quarter or month. Then, divide that number by your previous quarter’s CAC (or your previous month’s CAC)
Current Quarter ARR (or MRR) - Previous Quarter ARR (or MRR) / Previous Quarter CAC (or Previous Month’s CAC)
Rule of 40
The Rule of 40 is a metric that was specifically designed for SaaS companies and is thought to be created by Silicon Valley investors. The idea is that your business’s growth rate and profitability should meet or exceed 40%.
The basic formula is:
Growth Rate + Profit = GP ratio, with your Gross Profit (GP) ratio being the metric that should be at least 40%.
The Gross Profit ratio might sound familiar if you’re in the financial world, as it’s often used to measure the performance and efficiency of a business from a profit lens.
But it’s important to remember that the Rule of 40 is just one metric, and that you shouldn’t panic if you don’t quite meet that 40%. While the Rule of 40 can provide a look into company performance, it’s generally used by startups with a ton of revenue growth potential, while more mature companies typically experience slower growth and steady performance.
How to Calculate SaaS Quick Ratio
One source describes the SaaS quick ratio as the “bright and shiny side of your business and the underbelly at the same time”, which is an accurate assessment of why this metric can be so attractive to investors.
With any SaaS business, you need to be focusing on getting churn to be as low as possible, so any metric that includes insight into churn is going to be valuable, and the SaaS quick ratio does just that.
The SaaS quick ratio calculation starts by taking your Monthly Recurring Revenue (MRR) calculations, New MRR and Expansion MRR, and adding them together. You can also swap out these two metrics for their Annual Recurring Revenue (ARR) equivalents if that makes more sense for your business.
- New MRR is the monthly recurring revenue earned from new subscriptions during a given month.
- Expansion MRR is the additional revenue gained from your company’s existing customers.
The result of adding these two metrics together is then divided by the sum of the Downgrade MRR and the Churn MRR.
- Downgrade MRR refers to a decrease in monthly recurring revenue caused by existing customers downgrading their plan, and thus paying less than they did the previous month.
- Churn MRR refers to customers leaving entirely, so the revenue that was generated from them the previous month no longer applies to the current month.
The quotient of these two final numbers — the New MRR and Expansion MRR divided by the Downgrade MRR and the Churn MRR — is your SaaS quick ratio.
Let’s take a closer look at that formula and what it means for your SaaS company.
SaaS Quick Ratio Formula
The Saas quick ratio formula is simple:
SaaS Quick Ratio = New MRR (or ARR) + Expansion MRR (ARR) / Downgrade MRR (ARR) + Churn MRR (ARR)
Here’s an example of it in action with a hypothetical SaaS company.
Company A achieves $30,000 in new SaaS subscription revenue for a business quarter, in addition to $50,00 existing revenue. But they also lose $16,000 to churn and $2,875 to downgrades. This company has a SaaS quick ratio of 4.2.
Ok, now that we have a number, we need to know more about what it means, including if it’s considered a good or bad ratio.
How to Determine a Good vs. Bad Saas Quick Ratio
SaaS entereprenuers often speak of a good and bad SaaS quick ratio number, and often savvy investors like the aforementioned Mamoon Hamid will only invest in a SaaS company with a quick ratio above 4.
SaaS Quick Ratio Number
Less than 1
Your business is in trouble — sustaining a SaaS business at this ratio would be extremely difficult. You need to fix your churn, and fit it fast.
Your SaaS company has growth, but it’s slow. Your CAC is likely high. An increased focus on retention is what’s needed here.
Greater than 4
Your company is growing efficiently and at a good pace. A SaaS quick ratio of more than 4 indicates that you’re making $4 in revenue for every $1 your company is losing.
In short, a SaaS quick ratio above 4 shows promising growth, a number between 1-4 indicates slow growth, and less than 1 means your business is on it’s way out.
Of course, this doesn’t tell the entire story behind a company’s revenue growth and efficiency, but we’ll get into that more in the next section.
Understanding SaaS Quick Ratio
We already know that the SaaS quick ratio is a measurement of your SaaS company’s inflow revenue (either MRR or ARR) against it’s outflow, but what does it actually tell us beyond the numbers?
In order to understand what exactly the final number you get means when you calculate your SaaS quick ratio, you need to know the context behind the numbers you’re calculating.
Here’s an example.
Let’s say you’re a SaaS company that sells multiple services. Doesn’t seem too farfetched, right? Tons of SaaS companies delve into more than one offering at a time. It gives customers choice and adds multiple revenue streams for the company itself.
If you’re using just one number — let’s say ARR — that encapsulates all the revenue from all your services, then you’re only seeing the very tip of the iceberg.
To add context to your calculations, follow these steps:
- First, separate your ARR by service.
- Use those individual numbers to calculate several quick ratios.
Following these steps will help you glean more information into how individual services are growing, rather than looking at the entire business revenue at once.
In this scenario, let’s say that you only measured the ARR for all your services together, and found that your SaaS quick ratio was greater than 4. Amazing.
But when you break it down further by service offering, you find that while subscriptions are through the roof, your support service is suffering, and badly.
You can see where we’re going with this: if you’re only looking at one spot in the sky through a telescope, then you’re missing out on the rest. It’s easy to get tunnel vision when looking at metrics, especially when you see successful numbers and are tempted to just take them at face value.
In order to completely understand what’s going on with your SaaS business, you need to look at every aspect of it with equal attention.
In short, while the SaaS quick ratio will give you a snapshot into your company’s growth and performance, it doesn’t provide the entire picture and should be used in conjunction with other metrics and analytics, including customer behaviour, for a complete story.
SaaS Quick Ratio and Startups
While Hamid views the SaaS quick ratio as an efficient measure of a SaaS company’s growth rate, there’s others that say it’s more of a directional metric than a measure of overall efficency.
Tomasz Tunguz, a Venture Capitalist, wrote an article back in 2015 about SaaS quick ratio that is often quoted on marketing and business websites.
His article asserts that it’s possible for a SaaS startup to have a high quick ratio, but also a high churn rate. While having a higher SaaS quick ratio is always better, it’s important to remember that just because a SaaS company might have a higher churn rate, that doesn’t mean it’s completely unsustainable for their specific business.
For example, a company could have a 15% monthly growth rate and still be sustainable at up to 5% monthly churn, or have a 20% monthly growth rate and sustain a 6.7% monthly churn — both churn metrics that would be setting off alarm bells and painting red flags according to most sources, which say that SaaS churn rates should generally be 3% or less.
But even the source we just linked points out sustainable churn metrics can vary for different companies, and that’s an important consideration.
Tunguz also points out in his article that the reason why some of these SaaS companies have higher churn rates is due to their market, in that “startups serving smaller customers will observe higher churn rates.”
Yes, churn is bad, but there are a ton of potential reasons as to why churn rates could exist: a customer paying their bill late is one, or the very nature of your business could see customer’s final bills fluctuating considerably from month to month.
For example, if you’re an email service provider that charges customers based on the number of contacts they store in your system, chances are you’ll see fluctuations in a customer’s bill month to month as they add and remove relevant contacts.
Or, if you’re a service like Slack that only charges based on the amount of active users, then it’s assured that a customer’s bill will be different every month.
Still, higher churn rates aren’t something to ignore, it’s just important to understand the context behind why they might be there.
The key takeaway here is that while high quick ratios are always better, it’s important to pay close attention to churn rates. The SaaS quick ratio is hailed to not hide these rates, but when you’re getting high growth numbers, it’s easy to ignore the numbers that went into that calculation and just take the ratio at face value.
SaaS companies are all about efficiency alongside high growth. There are tons of SaaS trends that support this assertion. Especially in the startup stages, high growth is incredibly important for SaaS companies. Even as SaaS companies grow, paying close attention to growth rate as a main metric retains its importance.
The SaaS quick ratio aims to provide a open book on your company’s performance.
That’s the main reason why investors and stakeholders use the SaaS quick ratio as a way to understand the revenue growth of a company: it highlights revenue gains to losses in a clear and concise way, as long as you know what you’re looking for and you remember to take a careful look at the numbers that go into the calculation.
As our world continues to change and business investing becomes more and more proactive, we’re sure to see more metrics like the SaaS quick ratio popping up that can quickly measure the health of a company in one quick calculation.
However, each component of the metric that you’re looking at, including SaaS quick ratio, is important to consider as a part of the overall story of a business. Focusing on a singular number alone isn’t going to give you all the information you need to determine whether a business is successful or not, so be sure to consider all the information you have in front of you.