Developing an Intuitive Understanding of the SaaS Quick Ratio

This is part of a series on business fundamentals for data professionals.

We use ratios a lot in business. A famous example of this is the P/E ratio, which every business student learns in their first year of school, and every public company CEO dreams about when they sleep.

What’s often more important beyond understanding the definition of a ratio, however, is understanding the intuition behind the numbers. In the world of Software as a Service (SaaS), the ‘SaaS quick ratio’ is often used as a measure for capital efficiency — that is, “are you growing well without spending ridiculous amounts of money?”

In this piece, I want to give you an intuition for what this metric means, beyond the usual “oh, a quick ratio of x means you’re a healthy business, and a ratio of y means you’re going to die.” I’ve written this piece with the data analyst in mind — which means I’m not assuming business knowledge of any kind.

Let’s begin.

The SaaS Quick Ratio Defined

The SaaS quick ratio is a measure of how efficiently a SaaS business can grow. It is not to be confused with the ‘quick ratio’ from finance, often called the ‘acid test ratio’. That ratio is about measuring how capable a company is at paying off its obligations. This ratio is about the changes in revenue in a SaaS business.

To calculate it, you use the following formula:

SaaS Quick Ratio = (New MRR + Expansion MRR) / (Churned MRR + Contraction MRR)

Let’s define these terms real quick:

• MRR means monthly recurring revenue.
• Many SaaS companies have multiple tiers of products. Think about how Slack costs more if you have more people in your org using the service. Or about how Hubspot has different tiers with different prices. If an existing customer increases the amount of money they pay you in a given month, this increase is known as expansion MRR.
• Churned MRR means the amount of revenue you have stopped receiving from customers who have cancelled their subscription in the previous month. Because churn is so important, we’ll talk more about this in the next section.
• Contraction MRR is the reverse of expansion MRR. This is the amount of money you’ve lost from a customer who’s downgraded their plan in the previous month.

Now let's go through a quick example. Let's say that last month, Acme SaaS Corp onboarded three new customers for $500 a month each. This means that their new MRR is $1500. Two customers upgraded their plans from the $500/mo tier to $800/mo tier. This means that expansion MRR is $600 (2 x an increase of $300).

At the same time, two customers cancelled their $500 subscriptions. So churned MRR is $1000. And one customer downgraded their plan from the $1000 tier to the $800 tier. Contraction MRR = $200.

Plugging that into the formula:

SaaS Quick Ratio = (New MRR + Expansion MRR) / (Churned MRR + Contraction MRR)

we get:

SaaS Quick Ratio = (1500 + 600) / (1000 + 200) = 1.75

It’s quite clear that the higher the number, the better. A positive number means that you are growing: that is, the amount of new revenue increases outstrips the amount of revenue you’ve lost. A negative number means you’re in a terrible, terrible spot: more customers are leaving you than you are gaining new ones.

VCs have high expectations for growth; they usually want startups to have a SaaS quick ratio of 8 or more. (The conventional wisdom is anything >= 4 is great if you are VC-funded, but I’ve linked to a piece that argues a quick ratio of 4 can mean a churn rate of 5%; this is a ridiculously bad churn number).

An Intuitive Understanding of SaaS

A SaaS business is a pay-as-you-go business. Customers pay for software on a monthly, quarterly, or yearly basis. This is great for the customer because they don’t have to pay up-front; it’s great for the SaaS business because recurring revenue produces a predictable income stream, and it’s great for investors who put their money in businesses, because people with money like making more money, and they especially like it if their money-making is predictable.

However, the flip-side of this model is that a SaaS customer can choose to stop their subscription at any time. This is known as ‘churn’, as we’ve explored earlier. Sample sentence: “oh, BigCorp customer is churning at the end of this month, we’ve going to lose $4000 in revenue”.

Churn is especially important because new customers don’t come cheap. To get a new customer, you often have to pay salespeople or buy ads in order to get them to consider your software. If, for instance, it takes $2000 to bring in a new customer (you pay $500 in Facebook ads, $1500 in salesperson commissions), and your product costs $100 a month, then a customer who churns after 3 months would have only paid $300 — meaning you would’ve made a loss of $1700 on them!

This fundamental idea is really important to grasp. When you make and sell products for a one-time payment, you usually recoup the cost of making or buying the product at the point of the sale. Let’s say that you sell phones. If you buy your phone for $1000 and sell it for $1300, then you pocket a profit of $300 the moment a customer buys a phone from you. This is not the case for subscription revenue. Instead, a business only makes money after the customer sticks around long enough to recoup the cost of customer acquisition.

In the case of our example above, it would take 20 months to recoup the cost of acquiring a new customer (given that the customer costs $2000 to acquire, and pays $100 a month). The good news? Well, every month after month 20 is nearly pure profit.

(This is, by the way, why investors like SaaS companies so much: managed well, a SaaS company with low churn is a money-printing machine.)

The upshot here is that churn really, really matters in a SaaS company. If your boss is asking you to add the quick ratio to a dashboard, she is likely asking because she’s worried about growth. But it is more likely that she is being asked to send her company’s quick ratio to her company’s investors — because this ratio is better used as an assessment of the company, not as a guide for operations.

Why The Quick Ratio Isn’t A Great Operating Metric

The quick ratio is a useful short-hand for comparing across SaaS companies. If you are comparing with other VC-funded startups, this number is expected to be high. This single number makes the quick ratio particularly useful for a VC who wants to see who in their portfolio of companies are doing well, and who are not.

In the case of a business operator, however, it’s often more useful to break the ratio down into its component parts. This way, you can ask the right operating questions when you attempt to influence them:

• For new revenue, how can you grow the number of customers you close each month? What if you changed the mix of customers you’re targeting? Or select a specific industry to target, perhaps?
• For expansion revenue, what product modifications might exist to encourage customers to sign up to higher tiers? Could you and should you run an ‘upgrade campaign’, with a time-limited discount, perhaps? Or could you make your product more valuable, and therefore more likely to be used successfully by your customers (therefore prompting growth to a higher tier)?
• A good churn number is 2% and lower because it means that a sizeable portion of the customers you're spending to acquire will stick around. For this metric, find out why your customers are churning. This might be due to something as simple as a bad onboarding and re-engagement flow, but is more likely to be something fundamental with the product itself. (Note: that last sentence is an understatement; tackling high churn is one of the most difficult problems in SaaS.)
• For contraction revenue, are there ways to encourage more compelling use cases in the product? Could you place those use cases in the higher tiers? Why? Why not?

The component metrics that go into the SaaS quick ratio are really the workhorses of the business operator. They give you monthly feedback on how you’re doing across all four metrics that matter most to your business. They are the real superstars of an internal company dashboard.

And with the explanation above, you now understand why.

This is part of a series of posts that explain business fundamentals to the data professional. For more updates, subscribe to our newsletter below: