There is a need for finance leaders to have an in-depth understanding of the financial efficiency of their companies. In-depth knowledge of how effectively you can convert dollars invested into revenue earned is vital. It is essential regardless of whether you are a more established business or an early-stage startup focused on growth at all costs.
No one else understands that efficiency, like finance does. The reason is because of its distinctive broad view of the company. But beyond the financial statements, how do you track them? This article covers the meaning of Financial efficiency, its importance, how to improve it, and the metrics essential for measuring it.
The Meaning of Financial Efficiency
Financial efficiency is a broad measure of how well a business converts costs associated with sales, marketing, and product development into revenue. There are many Financial efficiency metrics to measure this. However, finance leaders should not just focus on tracking only one of these metrics. Numerous metrics could show your effectiveness in generating annual recurring revenue (ARR), depending on your business model and SaaS pricing strategy.
The first step in truly understanding your financial efficiency is to identify the appropriate ratios to analyze how particular assets and liabilities of your company turn into revenue. Furthermore, the more insight you have into these ratios, the easier it will be for finance to predict future profitability and spot growth opportunities.
Why is Financial Efficiency Important to Leaders and Finance Teams?
Finance can not just report the numbers if it wants to be a real strategic partner in the company. Being off on your numbers is not good. But, not being able to know 'why' is even worse.
Financial efficiency metrics help guide finance in the right direction for them to identify insights about the company. They can provide insight into whether your growth trajectory is sustainable or not. Financial efficiency metrics also reveal areas where you might be able to improve the health of your company.
Consider the connectivity firm Zapier ($140 million in Annual Recurring Revenue, ARR) as an illustration. Prioritizing employee productivity through automation was one prominent strategy for their profitable growth.
Zapier saw an opportunity to create expense reports by using finance automation. As a result, this helps in improving employee self-service experience while saving time the finance team would normally spend classifying data. With more insight into expense data, finance could reallocate that time to cost efficiency analysis and path-planning for increased profitability.
In the case of Zapier, understanding financial efficiency was one of the factors that enabled the company to scale its revenue with just 1.4 million dollars in funding. It shows how finance, when leadership understands the "why" behind the numbers, can help a company grow strategically.
The Eight Most Useful Financial Efficiency Ratios to Track
Financial efficiency ratios measure how efficiently a company can convert its total assets and products, including physical inventory and software, into profits. Finance teams can effectively tell a company's story using financial efficiency ratios and metrics. Each of these ratios is effective on its own.
However, assembling them will not only enable your corporate finance team to describe the business path to growth to executive leadership, shareholders, and key stakeholders. It will also help your corporate finance team to apply a strategic lens to it.
Furthermore, there is no definite list of the essential financial ratios to analyze your company. The reason is that choosing the proper financial ratios depends on your company context. For instance, liquidity ratios are vital for private companies but are less significant for early-stage startups.
Also, while software businesses do not need to track metrics such as inventory turnover or asset turnover ratio, eCommerce businesses do. Additionally, hardware companies need an in-depth understanding of large-scale depreciation and supply chain efficiency. But for SaaS companies, in particular, the following financial efficiency ratios should be at the top of their list:
1. The Rule of 40
The Rule of 40 states that a SaaS company should aim for a result of 40 percent or higher when adding its growth rate and profit margin. It means the final result of your Rule of 40 calculation should ideally be 40% or above. That is the standard benchmark for sustainable growth, especially for later-stage SaaS companies.
The Rule of 40 summarizes an operational performance of a company by showing how its profitability and growth balance one another. Thus, making it easy for management teams, boards of directors, and investors to understand the company's overall sustainability.
You can calculate the SaaS rule of 40 by summing your growth rate and profit margin percentages. Therefore the formula for the SaaS Rule of 40 is:
2. LTV: CAC Ratio
The lifetime value to customer acquisition cost ratio is another sales and marketing efficiency metric. LTV: CAC Ratio provides you with your Return on Investment (ROI) per customer, so you can understand how effectively your sales and marketing strategies generate revenue. With this information, you can determine whether your customer acquisition strategies are long-term viable so you can make any required adjustments on time. To calculate this Ratio, you divide the customer lifetime value (LTV) by your customer acquisition cost (CAC). Therefore, the formula for LTV:
3. SaaS Magic Number
The SaaS magic number is a popular metric that software-subscription businesses use to measure their sales efficiency. It gives you a comprehensive understanding of the growth rate of your company.
The SaaS magic number measures the amount of revenue (dollar worth) generated (ARR) by a company for each dollar spent on marketing and sales to acquire new customers (CAC).
As a SaaS business owner, you can calculate the magic number for your business by following these calculation steps:
- First, deduct your prior quarter-Annual Recurring Revenue (ARR) from your current quarter-ARR
- Then divide the result by your total Customer Acquisition Cost (CAC) from the previous quarter
Therefore the formula for SaaS Magic Number
When you know your magic number (measured on a scale of zero to one), you can assess how efficient your sales and marketing initiatives are. For instance, after calculating your SaaS magic number and the result is below 0.5, then you have to continue working to improve your product-market fit.
And if the result is close to 0.75, this means that your sales efficiency is on track. On the other hand, if your SaaS magic number is 0.75 or higher, you can confidently invest more into your sales and marketing efforts.
4. CAC Ratio
Also known as the Cost of ARR, your Customer Acquisition Cost ratio helps you to understand the effectiveness of your company's sales and marketing efforts. CAC ratio also tells you if the marketing and sales campaigns are worth your current spending.
While CAC measures the cost to acquire one new client, the CAC ratio compares your sales and marketing costs to new and expansion ARR. To calculate your CAC Ratio, you divide your marketing and sales expenses by new and expansion ARR.
Therefore the formula for calculating your CAC ratio is:
By comparing sales and marketing expenses to new and expansion ARR, you can determine the percentage of new customers you need to acquire to recover that month's sales and marketing expenses in a year. For instance, if your CAC Ratio is 50%, the new customers acquired in a month will help you recover 50% of that month's marketing and sales expenses in a year.
5. Net Sales Efficiency
The Net Sales Efficiency accounts for churns and new customer acquisition by examining sales and marketing expenses with new ARR. This metric gives you a target rate of return for your marketing and sales efforts. Additionally, Net sales efficiency accounts for the impact of your customer success team on retaining customers.
To calculate your Net Sales efficiency, divide your net new ARR by your sales and marketing expenses. Therefore the formula for Net Sales Efficiency is:
However, teams often calculate this metric per quarter by dividing the net new ARR for the quarter by sales and marketing expenditures for the same period. But if you want to calculate net sales efficiency by month, you change ARR to MRR.
6. Net Revenue Retention
The growth trajectory of a business depends highly on retention. Net revenue retention reveals whether current customers find your product valuable and whether they are satisfied with other product factors like customer service, pricing, and reliability.
To calculate net revenue retention:
- First, you add your current-month starting monthly recurring revenue (MRR) to the change in MRR
- Then divide the result by the starting monthly recurring revenue (MRR)
Therefore the formula for calculating Net Revenue Retention (NRR) is:
120% is the standard benchmark for strong Net Revenue Retention (NRR). It means your SaaS revenue is increasing rapidly as current customer accounts gain value over time rather than churning. Strong NRR indicates the possibility of significant growth that is not entirely dependent on new customer acquisition.
7. Human Capital Efficiency
Effective headcount planning is a significant factor for a company's growth as it is the single-biggest expense affecting profit and revenue. Human capital efficiency measures the number of personnel across the organization to forecast future ARR and determine how many employees are needed to maintain the current ARR.
The inefficiency of human capital efficiency may indicate misaligned ratios for resources at the department level or problems with customer acquisition. To calculate Human Capital Efficiency, you divide your total ARR by the number of full-time (FT) employees.
Therefore the formula for Human Capital Efficiency is:
8. AR Turnover Ratio
Given that revenue is the amount of money made from what your business sells, you need to understand how efficiently it collects payments from clients. Also known as the Debtor-Turnover Ratio, the Accounts Receivable (AR) Turnover Ratio measures how effectively a business receives money from its customers.
You can calculate your AR Turnover Ratio by dividing your net credit sales by your average accounts receivable. Therefore the formula for AR Turnover Ratio is:
Note: It is preferable to calculate AR turnover per month rather than multiplying it by 12, given that customer acquisition and retention vary.
Tips for Improving Financial Efficiency
The most financially efficient businesses look for ways to maximize operational function productivity while reducing costs where feasible. To improve your financial efficiency, you need to look for opportunities to optimize every aspect of your business.
It includes optimization from customer communications to everyday tools and processes that drive it. You can improve your financial efficiency with the following tips:
1. Increase the Agility of Scenario Analysis
There will not be much time to update financial models to analyze various scenarios continuously if finance gets stuck in manual procedures. Strong scenario analysis examples predict the base, worst-case, and best-case situations.
Working together with department heads offers some solutions for building more accurate models. However, finance still needs to gather data from various systems to develop a coherent story for each scenario.
To quickly bring their findings to life through a model, finance needs tools and technology that smoothly integrate actuals and provide updated, real-time data without relying on manual input. Making scenario analysis more efficient allows you to see potential strategic decision outcomes more clearly and, ideally, make decisions that will increase financial efficiency.
2. Automate Accounts Receivable (AR)
Your Account Receivable (AR) turnover ratio reveals the success of your collection process. Low turnover indicates that your customers take longer to pay you. However, you can improve the collection by avoiding delays that could harm cash flow. By doing this, you can increase your financial efficiency.
When it comes to creating and sending invoices, reminders, and reconciling payments with your accounting systems, AR automation can be helpful. But automating financial data can do more than that. It can help ensure that your chart of accounts structure is up to date, making it easier to track AR metrics.
Let us say monthly subscriptions are the main focus of your business model. In a situation like this, customers should then be able to set up auto-payments too. As a result, this will give you a more consistent and controllable cash flow. Also, your finance team will have more time to gather information and assist in making more proactive decisions based on more accurate data and forecasts.
3. Improve Interdepartmental Cooperation Between Finance and the Other Departments
No one is better at numbers than finance. You can assist in identifying particular areas for improvement when you unveil insights into them for various department leads. However, some people will find it hard to understand your complex spreadsheets.
Finding a shared language within your company is necessary for improving collaboration. Finance needs to break down the numbers and have discussions with department and executive leaders to ensure the working capital and budget are in place for ideal, sustainable growth.
4. Promote More Data-driven Marketing Strategies
One of the most challenging aspects of a business to plan is marketing. How marketing activities relate to revenue is so vague and uncertain because of the constant change in campaigns and promotions.
Marketing requires ongoing facilitation. And data informs the discussions and some of the following inquiries you need to have with your marketing team about budget:
- Do you know how much you should spend on advertisements?
- Is there any event that needs more overhead than in the previous quarter?
- What short-term marketing initiatives, such as blog posts, webinars, and templates, generate the most leads for your pipeline, and how much does it cost to create these assets?
Driving financial efficiency becomes easier when you understand better the marketing strategies that work and those that do not.
Easier Way of Improving Financial Efficiency Using Strategic Finance Platform
If the numbers are off, the finance team will not accurately calculate the financial efficiency ratios that reflect the company's current and future position. However, finance teams are often stuck spending all their time verifying the accuracy of the previous month's balance sheet, income statement, and cash flow statement.
But Strategic Finance Platforms automates the time-consuming part of data collection and updates your data in real time. As a result, it enables your finance team to proactively collect data and strategize for your short- and long-term growth objectives.
These platforms unlock the aforementioned financial efficiency ratios and many more. These strategic finance platforms contain over 100 metrics, including the SaaS quick ratio, gross revenue retention, net burn, and net income.