The role of finance cannot be limited to merely reporting past events. You have to provide a clear and concise picture of the financial health of the rest of the company.
Doing this will also help you to gain strategic, progressive insights in the process. However, financial ratios provide the foundation for completing that task. As a result, there is a need for you to learn the essential financial ratios to track.
Why are Financial Ratios Important?
A finance team can explain company performance using financial ratios like profitability and efficiency ratios. These ratios are essential for moving beyond the conventional monthly cycle of creating cash flow analyses, balance sheets, and Profit and Loss (P&L) statements for financial reporting. In addition, they are also essential for taking on a more strategic role within the company.
Furthermore, using the proper financial ratios can enable you to determine whether the current growth pattern of your company is sustainable. Using the proper ones can also tell you how effectively your billing team collects payments and whether you should invest in marketing or focus more on your product. They can also provide you with information about the potential of your company to attract investors.
Top 10 Financial Ratios You Can Use to Analyze Your Company
As a business owner, you need to perform financial ratio analysis to determine if you are on the growth path and address problems before they become serious. Listed below are the top financial ratios that are essential for analyzing a company:
1. The Lifetime Value to Customer Acquisition Cost (LTV: CAC) Ratio
The lifetime value to customer acquisition cost ratio compares the money a customer spends with you during their entire time as a customer to the cost of acquiring them as your customer.
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.
LTV: CAC Ratio Calculation
To calculate your LTV: CAC Ratio, divide the lifetime value (LTV) of a customer by your customer acquisition cost (CAC)
2. SaaS Quick Ratio
The SaaS Quick Ratio compares customer bookings and upgrades to customer churn and downgrades to measure how effectively a company is growing. It can assist you in determining whether your current growth is sustainable or whether you need to take steps to lower customer churn (reduce losing customers). The higher your SaaS quick ratio is, the higher your position improves.
SaaS Quick Ratio Calculation
You can calculate your SaaS Quick Ratio by dividing your new Monthly Recurring Revenue (MRR) by your lost MRR. Here, your new MRR includes expansion or upgrades. On the other hand, your lost MRR consists of contraction or downgrades.
3. 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. This calculation 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.
Rule of 40 Calculation
You can calculate the SaaS rule of 40 by summing your growth rate and profit margin percentages. Any result higher than 40 percent is considered a strong one.
4. SaaS Magic Number
The SaaS Magic Number reveals the effectiveness of your marketing and sales efforts within a given quarter or month. In turn, it helps you to decide when to pull back or invest more in your marketing and sales efforts.
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 expand your sales and marketing efforts.
SaaS Magic Number Calculation
As a Saas business owner, you can calculate the magic number for your business by following these simple 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
Note: The formula above uses quarterly revenue figures to calculate the primary SaaS magic number. However, depending on your usual sales cycle, you can use Monthly Recurring Revenue (MRR) to arrive at a monthly magic number. You can also calculate your magic number on an annual basis.
5. Net Revenue Retention (NRR) or Net Dollar Retention (NDR)
Net revenue retention reveals whether current customers find your product to be valuable and whether they are satisfied with your customer service, pricing, and reliability. Good knowledge of the revenue retention rate of your company will help you better understand its growth trajectory.
Net Revenue Retention (NRR) Calculation
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)
6. Gross Margin or Gross Profit Ratio
Gross Margin or Gross Profit Ratio compares your company's gross margin to its total revenue. It makes it easier for you to understand how much (the percentage) of each dollar in revenue to keep as gross profit.
For instance, a gross profit margin of 80 percent means that out of every dollar you bring in, you keep 80 cents which then goes to your operating expenses and profit. The remaining 20 percent is what you spent on your product as a cost of revenue.
Gross Profit Ratio Calculation
You can calculate your gross profit ratio by following these simple steps:
- Deduct the cost of goods and services (COGS) from your total revenue
- Then divide the result by your total revenue
- Finally, multiply the result by 100 to create the gross profit ratio
7. Net Profit Margin
The Net profit margin compares a business's profits to its total revenue. Just like the gross profit ratio, It enables you to understand how much profit your company retains for each dollar it generates. Net profit margin measures how efficiently a business operates and how much profit it makes on the bottom line.
Net Profit Margin Calculation
To calculate Net Profit Margin:
- First, divide your net profit by your total revenue
- Then multiply the result by 100
8. AR Turnover Ratio
Also known as the debtor-turnover ratio, the Accounts Receivable (AR) Turnover Ratio measures how effectively a business collects money from its customers. The higher your Accounts Receivable Turnover Ratio, the better your business is at obtaining payments from customers' accounts payable teams.
AR turnover Ratio Calculation
You can calculate your AR Turnover Ratio by dividing your net credit sales by your average accounts receivable.
9. Customer Acquisition Cost (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.
The CAC ratio compares your sales and marketing costs to new and expansion ARR, whereas CAC measures the cost to acquire one new client. 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.
CAC Ratio Calculation
To calculate your CAC Ratio, you divide your marketing and sales costs by your new and expansion ARR.
10. Free Cash Flow Margin
The free cash flow margin shows how effectively a business converts sales into cash. Using a free cash flow margin, you can also track your free cash flow over time, which reveals how efficiently you generate free cash flow from your sales.
Free Cash Flow Margin Calculation
To calculate your Fresh Cash Flow Margin, you divide cash flows from operating activities by net sales.
Telling the Full Story of Your Company Using Financial Ratios
The aforementioned financial ratios are well-applicable to SaaS finance metrics for new ventures and other kinds of small businesses. However, other financial ratios are suitable for those in a different sector or who are already renowned. These comprise different debt ratios, leverage ratios, and liquidity ratios. Among the notable ones are:
- Current Ratio or Working Capital Ratio: Current Ratio is a liquidity ratio that compares the current company's assets to its current liabilities. In other words, it compares assets that can be converted into cash within a year to the total liabilities or short-term obligations that a company must pay off within a year.
- Acid Test Ratio: Like the current ratio, the acid test ratio is also a liquidity ratio. The acid test ratio compares a company's short-term assets that can be converted into cash immediately to the liabilities it must settle immediately.
- Cash Ratio: This is another liquidity ratio that compares a company's Current Assets to its short-term debt or current liabilities. Here, the company's Current Assets include both cash and liquid assets.
- Return on Equity (ROE) Ratio: This is a profitability ratio. Return on Equity compares a company's profitability to its equity shareholders.
- Debt-to-Equity (D/E) Ratio: D/E ratio is a leverage or debt ratio that aids a company in understanding how much of its funding comes from shareholder's equity or investors' equity. In addition, it helps companies understand how much of their financing comes from debt. Debt-Equity-Ratio measures the financial leverage of a company.
In-depth knowledge of these financial ratios and the ones most essential to your business enables you to tell the story of your business. It helps you to fully explain your business growth, sustainability, health, and success.
Financial ratios give you information that can aid in determining the best strategic direction for your company. They can also assist you in finding out the value and share price of your company's stock. Additionally, they can also help you determine whether investors will be interested in what you have to offer.