Put simply. The SaaS quick ratio measures the growth efficiency of a business. It assesses the probability of a company's revenue growth.
The SaaS quick ratio reflects a company's revenue increase by comparing its revenue inflows and outflows.
Mamoon Hamid, the acclaimed venture capitalist, is credited with formulating the SaaS quick ratio as a fast and efficient way of measuring a SaaS business's health.
The ratio, which he derived from the accounting quick ratio formula, has become a highly regarded metric for investors and tech-savvy business people to evaluate the condition of both established and new SaaS companies.
How to calculate SaaS quick ratio?
For your SaaS Quick Ratio Calculation, you must have these metrics at hand
- MRR – Monthly Recurring Revenue
- New MRR – MRR from new customers
- Expansion MRR – MRR from existing customers
- Churn MRR – MRR lost due to cancellations
- Contraction MRR – MRR lost from existing customers
SaaS quick ratio vs. the acid test ratio
You must understand the SaaS quick ratio if you own or are vested in a SaaS business.
Several metrics can determine success measuring your company's ability to grow, the SaaS quick ratio being perhaps the most useful among them.
It is easy to confuse it with the finance quick ratio because of the likeness in the names, though that is where the similarity ends.
Unlike the finance quick ratio, also known as the acid test ratio, which essentially measures the ability of a company to meet its short-term liabilities, the SaaS quick ratio has no connection to the liquidity position of the business. It strictly reflects the growth potential of your company.
However, both ratios are vital for shareholders to analyze the risks associated with the business.
Why is the SaaS quick ratio important?
Arguably, the SaaS quick ratio is essential to determine a company's growth efficiency. Industry professionals and potential investors put a heavy weight on the importance of the SaaS quick ratio and require companies to provide their estimates of a quick ratio.
This quick ratio allows prospective investors to evaluate the growth probability and viability of said growth relating to a company.
The SaaS quick ratio is a far superior estimate of a company's growth prospects compared to other metrics because it considers both the positive and negative sides of the company's growth.
It is prudent to maintain a favorable SaaS quick ratio before considering investing in the growth of a business. This is because a low SaaS quick ratio, for example, 2, means losing half your new MRR while simultaneously putting money into acquiring new customers. This means placing a lot of cash into the growth of a business as opposed to one with a high quick ratio.
A 'good' SaaS quick ratio can be very useful when vying for follow-on funding from investors.
Unfortunately, many new investors and entrepreneurs continually focus on metrics that can hardly be linked to sustainable financial performance. They are usually more focused on metrics comparing their performance with competitors rather than their growth potential.
What does it mean to get a low or high SaaS quick ratio?
Generally, a low quick ratio is an indicator that the company is facing difficulties in maintaining its growth in terms of revenue. It means that instead of generating revenue to contribute to the business growth, it is used to buffer the impact of lost revenue due to churns or downgrades by customers.
Conversely, a high quick ratio means a high and stable growth in revenue for the company. In other words, a high quick ratio implies growth in the company's revenue, even after covering the lost revenue from churns.
What is a good SaaS quick ratio?
A quick ratio of 4 is considered an industry-accepted standard. Although every company has a unique position, there is no consensus on the accuracy of this benchmark.
In general, however, a quick ratio of more than 4 is considered the mark of a strong business that manages to maintain high growth rates.
A quick ratio of 4 means that the rate at which the company earns its revenue is 4 times faster than the revenue it loses.
The higher the number of the SaaS quick ratio, the better. Nevertheless, a quick ratio of less than 4 doesn't necessarily indicate that your company is failing or facing major crises.
Every business is different, so there can be no fixed number. In essence, what matters is that you reduce churn as much as possible.
What do different SaaS quick ratios mean for your company?
A SaaS quick ratio < 1
Your SaaS startup is done for. It is possible for you to sail through a month or two with such a modest quick ratio - if you have a good customer base - but even then, a quick ratio this low means that the churn will put an end to your company.
A SaaS quick ratio greater than 1 but less than 4
Indicates growth, but you must consistently incur the costs and efforts associated with garnering new customers to compensate for the customers downgrading or churning. The growth is slow and inefficient.
SaaS quick ratio > 4
This growth rate is considered good and efficient. It basically means that you are making $4 for every $1 lost.
The Best Way to Maintain a Quick Ratio of 4
You must maintain a minimalistic churn rate or extraordinarily high growth to sustain a favorable quick ratio.
How can you better a low SaaS quick ratio?
If your company projects a sturdy MRR growth rate, customer retention is key, but you are still left with a low SaaS quick ratio. Engaging with and making a consistently satisfying experience for existing customers is essential. Furthermore, issues causing the churn need to be identified and addressed.
Why your primary focus needs to be on churn
You will likely have an exceptionally high quick ratio when your company starts out. This is due to the low churn and high growth experienced by new businesses. After all, it's easy to grow by 100% per month if you have a monthly recurring revenue of $50 and achieve 0% churn if you only have a couple of customers.
Although, as your company grows, it gets more and more challenging to maintain those high growth rates.
As your business matures, your focus needs to switch. To keep your revenue growth healthy, sustainable, and predictable - churn needs to become your primary focus.
Pros of using the quick ratio metric
- It focuses on the business areas that require particular attention to promote sustainability.
- It's highly advantageous and indicative for subscription businesses with a high customer value and a low price point.
- If you own a subscription business MRR/ARR is everything to your business. · It allows you to proactively identify and act upon potential problems.
- You can assess the state of the company weekly if desired.
- It is straightforward to calculate and comprehend.
SaaS companies are exceptional in the world of business. While the typical business model relies on big transactions to generate growth in the company's revenue, a SaaS company is dependent on a higher volume of smaller transactions and recurring revenue through subscriptions and upgrades.
This makes measuring the performance of a SaaS company difficult. You need to observe information like upgrades and downgrades, seasonality, churn rate, etc., to assess how the business is doing.
This is where the SaaS quick ratio comes in. It allows you to easily and quite effectively measure your SaaS company's growth.
The SaaS quick ratio exposes the vulnerable points of your SaaS company, through churn, quite plainly.
The SaaS magic number and the rule of 40
When talking about the SaaS quick ratio, the SaaS magic number and the Rule of 40 are also regularly considered. These two metrics also measure the SaaS businesses' growth rate efficiency, albeit using different approaches.
The SaaS magic number measures the sales efficiency of a SaaS company by analyzing the money spent on sales and marketing. It shows the company revenue growth for every dollar you spend on marketing.
The Rule of 40, believed to be coined by Silicon Valley investors, states that your business's growth rate and profitability should equal or surpass 40%.
SaaS companies are focused on high growth. This is especially true in the startup stages of a SaaS business.
A high growth rate is vital for any business, but exceptionally so for SaaS companies because they depend on the sales volume for their sustainability.
The quick ratio metric retains its importance throughout the lifecycle of a SaaS business. Even well-established SaaS companies with a solid customer base need to pay close attention to their growth rate as the primary metric.
A SaaS company's quick ratio aims to provide a clear-cut picture of its financial performance.
This is the main reason investors and stakeholders prefer to use the SaaS quick ratio to assess the potential risks associated with a business and to get a better idea regarding the revenue growth potential of a company. It underlines and compares the revenue gains to losses in a simplified way.
In today's world, where technology has all but taken over, and the ways of doing business are constantly evolving, investors are becoming increasingly proactive. Metrics like the SaaS quick ratio, which allow a brief glimpse at a company's performance with one quick calculation, have become paramount to staying in the game.
Nevertheless, it is to be noted that each component of the quick ratio metric needs to be considered as a part of the overall story of your business, along with other measures and factors.
Focusing on a singular number cannot give you all the information you need to determine the success of your business. Each business is unique, with its own unique circumstances, and it needs to be regarded as such to get an accurate picture of its performance.