Fast growth isn't always the same as healthy growth: but how can you tell if your SaaS startup has overstretched? And how can you tell if you're growing in a smart, sustainable way?
Today, I'm taking a look at the SaaS Quick Ratio: a quick and effective way to measure the health of your revenue growth.
What is the SaaS Quick Ratio?
In its original incarnation, the Quick Ratio is an accounting concept, designed to measure how quickly a company can liquidate its available assets to cover its current liabilities.
Sounds fun, right? Thankfully, we're looking at a different variant. Devised by serial investor and Social Capital co-founder Mamoon Hamid, the Quick Ratio we're interested in is designed to offer an at-a-glance look at the health of your SaaS startup's revenue growth.
The SaaS Quick Ratio Formula
SaaS Quick Ratio = (New MRRt + Expansion MRRt) / (Churned MRRt + Contraction MRRt)
The formula for calculating your SaaS Quick Ratio relies on four crucial SaaS metrics:
- New MRR (Monthly Recurring Revenue) is revenue gained from new subscriptions.
- Expansion MRR is revenue gained as a result of successful upselling and cross-selling.
- Churned MRR is revenue lost as a result of customers cancelling their subscription.
- Contraction MRR is revenue lost as a result of customers downgrading their subscription.
In simple terms, the SaaS Quick Ratio compares your revenue growth over a certain time period (as shown by New MRR and Expansion MRR) with your revenue shrinkage over the same timeframe (churned MRR and contraction MRR): creating a simple ratio of growth to churn.
Why the SaaS Quick Ratio Matters
Say your revenue is growing by £1,000 per month. We might assume that growth would break down as follows:
+ £1,000 MRR, - £0 churn
But there are all-manner of other ways that growth could be happening:
+ £2,000 MRR, - £1,000 churn
+ £5,000 MRR, - £4,000 churn
Though the overall growth rate is the same, the underlying health of these businesses is very, very different. The last company is having to generate £4,000 of new revenue, each and every month, just to keep its head above water.
Simple measures of growth wouldn't always pick up on this disparity, but the SaaS Quick Ratio would: allowing you to see how sustainable your growth is, and how efficient (or inefficient) your current strategy is.
SaaS Quick Ratio Benchmarks
So what does a "good" SaaS Quick Ratio look like?
A hypothetically-perfect SaaS startup with 0% churn would have an infinitely large Quick Ratio (try and plug 0% churn and contraction into that formula and you'll see why). From that, we can imply that the greater your SaaS Quick Ratio, the larger your revenue growth and/or the lower your churn.
"Bigger is better" isn't a particularly actionable piece of advice, but thankfully, there are a couple of Quick Ratio benchmarks we can use to gauge the health of our own growth rate.
Quick Ratio < 1
A ratio of less than 1 means you're losing revenue from churn faster than you can replace it with new MRR. If you sustained this ratio for more than a month or two, your company would be in serious trouble.
Quick Ratio 1 - 4
A ratio between 1 and 4 means your revenue is growing faster than your churn rate, but crucially, you're growing in an inefficient way: high churn is eating away at your growth potential (like the examples above).
Quick Ratio > 4
The "optimum" SaaS Quick Ratio you'll hear banded around is 4, put forward by founders and VCs (including Mamoon Hamid) alike. They recommend a target benchmark of 4 for two reasons:
- To hit a Quick Ratio of 4, a SaaS company needs to be adding $4 in revenue for every $1 lost through churn or contraction. That creates a steep growth curve, and minimises the volatility associated with high churn: perfect for investment.
- The benchmark also holds-up in the real-world. When InsightSquared analysed some of the fastest growing SaaS companies, they found an average Quick Ratio of 3.9. Chances are, if you can get your SaaS Quick Ratio to 4, and hold it there, you're on a path to scale.
Sustaining Your SaaS Quick Ratio
So what's the best way to sustain a Quick Ratio of 4?
To hit that target, you'd either need exceptionally low churn, or exceptionally high growth.
Data from Tomasz Tunguz suggest that the median SaaS business has a yearly churn rate of about 10%, which equates to a monthly churn rate of 0.83%.
Plugging that into a rearranged Quick Ratio formula [SaaS Quick Ratio = (Monthly Growth Rate + Churn Rate)/Churn Rate], we generate a necessary monthly growth rate of about 2.5%:
Quick Ratio = 4 = (2.49% + 0.83%) / 0.83%
Taking it a step further, Lincoln Murphy suggest that best-in-class SaaS businesses lose even less revenue to churn: about 7% churn a year, or 0.58% per month, equating to a required monthly growth of just 1.74%.
4 = (1.74% + 0.58%) / 0.58%
Doable, right? Now compare that to companies with higher monthly churn: say 5% and 10%.
In order to maintain that same ratio of grow to churn, these companies need to be growing at a much, much faster rate: 15% and 30%, respectively. Month on month. Not quite so doable.
4 = (15% + 5%) / 5%
4 = (30% + 10%) / 10%
So what can we take away from this? Three things:
1) The SaaS Quick Ratio Reveals Your Revenue Health
There's a difference between growth and healthy growth, and the SaaS Quick Ratio can show you the difference.
2) 4 is a Good Benchmark to Aim For
A Quick Ratio greater than 1 is an important hallmark of health, but if you want to raise your sights a little higher, a ratio of 4 is a good place to aim. It's a sign that your business is growing in a healthy, sustainable way, and if you can maintain the ratio as you begin to scale, you'll likely be a great fit for investment.
3) FOCUS ON CHURN FIRST, GROWTH SECOND
In the early days, it's possible to have a super high Quick Ratio, fueled by low churn and high growth. After all, it's easy to grow by 100% per month if your starting point is $100 MRR; and if you have three customers, 0% churn is pretty likely.
But as your company grows, it gets harder and harder to sustain those high growth rates (there's a reason unicorns are so rare).
As your business matures, your focus needs to switch. In order to keep your revenue growth healthy, sustainable and predictable, churn needs to become your primary focus.