Whether you’re an early-stage, growth-at-all-costs start-up or a more mature company, knowing how to properly convert dollars invested into revenue gained is important. Finance has the unique, big-picture perspective of the business to understand that efficiency better than anyone else.
But how do you actually go about tracking it beyond the financial statements? Here’s how to think about financial efficiency in your company: why it’s important and which metrics to track.
What is Financial Efficiency?
Financial efficiency is a big-picture measure of how successful a company is at turning expenses from product development, sales, and marketing into revenue.
However, there is no single “financial efficiency” metric that finance executives should be tracking. Depending on your business model and SaaS pricing strategy, many different metrics could highlight your efficiency in generating annual recurring revenue (ARR).
Understanding your financial efficiency begins with determining the appropriate ratios for determining how your company’s assets and liabilities are converted into revenue. And the more data you have about those ratios, the easier it will be for finance to forecast future profitability and spot growth opportunities.
Why Do Finance Teams and Leaders Care About Financial Efficiency?
If finance wants to be a true strategic partner in the business, it can’t just report the numbers. The only thing worse than being off on your numbers is not knowing why.
Financial efficiency metrics help steer finance in the right direction when it comes to identifying business insights. They can reveal whether or not your current growth trajectory is sustainable, as well as areas where your company’s health could be improved.
Take, for example, the connectivity company Zapier ($140 million in ARR). One prominent strategy toward their profitable growth included prioritizing employee productivity
Zapier saw an opportunity to leverage finance automation for expense reporting, giving employees a more self-serve experience while freeing up time the finance team would typically spend classifying data. Finance could re-allocate that time to assessing cost efficiency and charting a course to improved profitability as a result of greater insight into expense data.
In Zapier’s case, financial efficiency insight is one of the reasons the company was able to scale revenue with just $1.4 million in funding. It demonstrates how finance can help a company expand strategically by understanding the “why” behind the numbers.
8 of the Most Important Financial Efficiency Ratios to Keep an Eye On
Financial efficiency ratios and metrics are powerful tools finance teams use to craft a company’s story. Each ratio, like a chapter in a novel, is powerful on its own. But when brought together, your corporate finance team can not only tell executive leadership, key stakeholders, and shareholders what the company’s path to growth looks like but apply a strategic lens to it.
But what are the most important financial ratios to consider when evaluating a company? There is no definitive list, and the context of your company matters.
Liquidity ratios are important to public companies, but they aren’t as useful for early start-up’s. An eCommerce business needs to track metrics like inventory turnover/asset turnover ratio, whereas software businesses don’t. And hardware businesses need to have a firmer grasp on supply chain efficiency and large-scale depreciation.
The following eight financial efficiency measures, in particular, should be top of mind for SaaS businesses.
SaaS Magic Number
The SaaS magic number is a sales efficiency metric that provides a holistic understanding of your business growth rate. This metric considers the dollars’ worth of revenue created (ARR) for every dollar spent acquiring new customers (customer acquisition cost, or CAC) through marketing and sales.
Here’s how to calculate the SaaS Magic Number:
SaaS Magic Number = Current Quarter ARR – Prior Quarter ARR/ Prior Quarter CAC
Once you have your magic number (which ranges from 0 to 1), you can determine how effective your marketing and sales activities are and if you need to invest more (if the number is larger than 0.75) or less (if the number is less than 0.5) in into those efforts.
Rule of 40
The Rule of 40 is a metric that balances growth and profitability against each other to determine the company’s sustainability. It’s calculated by multiplying your growth rate by your profit margin percentages.
Here’s how to calculate the Rule of 40 financial ratio:
Rule of 40 = Growth Rate % + Profit Margin %
When you calculate your Rule of 40, it should ideally equal 40% or higher. That is the common benchmark for long-term growth (especially for later-stage SaaS companies).
The LTV:CAC ratio is another sales and marketing efficiency metric that determines ROI per customer. You calculate the ratio by dividing customer lifetime value (LTV) in the numerator by CAC.
How to calculate the LTV:CAC Ratio:
LTV: CAC Ratio = LTV/ CAC
With the ratio, you can assess the long-term feasibility of your customer acquisition strategies and make any necessary modifications ahead of time.
Customer acquisition cost, which measures the cost of acquiring a new customer, plays a role in many of the ratios above. But the CAC ratio itself drives conversations around the success and improvement of current and future sales and marketing campaigns.
Here’s the formula for how to calculate the CAC Ratio:
CAC Ratio = Sales & Marketing Expenses/ New & Expansion ARR
When you calculate this ratio, you compare marketing expenses to new and expansion ARR to discover the percentage of new customers you need to gain to recoup that month’s sales and marketing costs in one year.
Net Revenue Retention
Retention is a vital component of a company’s growth strategy. Net revenue retention determines not only how valuable your product is to current customers, but also how satisfied they are with other aspects of the product, such as pricing, reliability, and customer service.
Here’s the formula for calculating Net Revenue Retention:
Net Revenue Retention = Starting MRR + Change in MRR/ Starting MRR
The common benchmark for a strong NRR is 120 %, which indicates that your SaaS revenue is snowballing as existing customer accounts gain in value over time rather than churning. A high NRR indicates that you could see rapid growth that isn’t just based on new customer acquisition.
AR Turnover Ratio
As revenue is the amount of income generated by what your company sells, you need to know how efficiently your company receives payments from clients. The accounts receivable turnover ratio is calculated by taking your net credit sales and dividing it by your average accounts receivable to determine how efficient your company is at payment collection.
Here’s the formula for calculating the AR Turnover Ratio:
AR Turnover Ratio = Net Credit Sales/ Average Accounts Receivable
Divide net credit sales by your average accounts receivable. Again, because customer acquisition and retention fluctuate, it’s preferable to calculate AR turnover per month rather than multiplying it by 12.
Net Sales Efficiency
Net sales efficiency accounts for new customer acquisition and churn by looking at sales and marketing spend alongside new ARR. This metric provides a target rate of return for your sales and marketing activities. It also takes into account the impact your customer success team has on customer retention.
Here is the formula for calculating Net Sales Efficiency:
Net Sales Efficiency = Net New ARR/ Sales & Marketing Spend
Net sales efficiency is frequently calculated on a quarterly basis. Take your net new ARR for the quarter and divide it by your quarterly sales and marketing spend. Change ARR to MRR if you want to calculate per month.
Human Capital Efficiency
A company’s growth relies heavily on effective headcount planning, which is the single biggest expense impacting profit and revenue. Human capital efficiency measures the number of employees across the organization to determine how many it will take to sustain the current ARR and create a forecast for a new ARR. Inefficiency in this metric could indicate problems with customer acquisition or misaligned departmental resource ratios.
Human Capital Efficiency Ratio:
Human Capital Efficiency = Total ARR/ Number of Employees
Divide your overall ARR by the number of full-time employees to calculate your human capital efficiency.
Financial Efficiency Begins with Agile Real-Time Data
When the numbers are off, your finance team won’t be able to accurately calculate the financial efficiency ratios that capture where your business is now and where it can go. But too often, finance teams are stuck spending all their time making sure last month’s balance sheet, income statement, and cash flow statement are accurate.
Finance needs tools and technology that automate the tedious parts of data collection and keeps the data updated in real-time so that finance teams can proactively gather information and strategize for immediate growth goals and beyond.