Cracking the Quick Ratio Code
What is the Quick Ratio?
The Quick Ratio originates in accounting, and is a company’s current assets over its current liabilities. Quick here means how fast a company can liquidate those assets to cover the liabilities. A company needs a quick ratio of greater than 1 to show that it can extinguish all of its liabilities with its available assets.
In SaaS, quick can mean two things: finding out at a glance how your company is growing, and growing your company quickly. The Quick Ratio, devised by investor and co-founder of Social Capital Mamoon Hamid, gives investors, founders, and team members an immediate view of a SaaS company’s growth efficiency.
There are four numbers that go into calculating your SaaS Quick Ratio:
- New MRR—how much new revenue you’ve added in your time window.
- Expansion MRR—the amount of existing revenue that has expanded, through upsells or upgrades, in your time window.
- Churned MRR—revenue lost from customers abandoning your product in your time window.
- Contraction MRR—revenue lost from downgrading customers in your time window.
The first two of those numbers define your revenue growth. The second pair are all about your revenue churn. Therefore, your Quick Ratio is essentially taking the two most important metrics for your SaaS company and mashing them together in an easy to understand ratio—growth over churn.
Whereas in finance, a company only needs to have a Quick Ratio of over 1 to operate successfully, in SaaS, this number needs to be a lot higher. Here is a rough rule of thumb to go by:
- Quick Ratio < 1: You’re dead. You could sustain a Quick Ratio of less than 1 for a month or two if you already have a good customer base, but anything longer and your churn is going to kill your company.
- 1 < Quick Ratio < 4: You’re growing, and the growth might look good, but you are making it more difficult for yourself as you have to constantly keep up high levels of customer acquisition to replace lost revenues. You will grow, but slowly, and less efficiently.
- Quick Ratio > 4: You’re growing at a good rate, and doing it efficiently. Hamid won’t invest in a SaaS company with a Quick Ratio below 4. This means that a SaaS company has to be adding $4 of revenue for every $1 it’s losing for investors to even start looking favorably upon it.
Efficiency is the key to the Quick Ratio. Customer acquisition is costly, whether it’s through a sales team or self-service. You are paying for each and every customer, and when you have a low Quick Ratio it means you are paying more for your growth through eventual loss of that revenue. If you can increase your Quick Ratio, you can grow and get your business to the right place quicker.
For more on benchmarking the Quick Ratio, check out this post or our 2016 SaaS Benchmarks.
Why The Quick Ratio is So Powerful
- Quick Ratio = Infinity—Firstly you could gain $2,000 without any churn. Then you are really crushing it. This would give you a Quick Ratio of infinity, which isn’t really helpful, but it could be realistic in the first few months of your SaaS growth when you are acquiring, but not losing, revenue.
- Quick Ratio = 2—Here, you’re gaining $4,000 in expansion or new MRR, but at the same time losing $2,000 from churn and downgrades. Customer acquisition is strong, but your customer retention is losing the company money at the same time. While you have strong growth overall, this churn problem is going to become more and more of an issue with time.
- Quick Ratio = 5—Here you are gaining $2,500 in extra revenue this month, less than with the Quick Ratio of 2, but, importantly, you’re losing far less. Instead of losing $2,000, you’re only losing $500.
Ultimately, you’re adding the same revenue in each of these scenarios, and growing at the same rate. However, by looking at the Quick Ratio, you can see easily whether this growth is sustainable. Sustainability allows you to continue adding revenue, but with the knowledge that you aren’t losing it at the same time. This means you can be confident to try the more expensive acquisition channels that are needed towards the later stages of growth, and aren’t constantly chasing revenue to stand still.
How Quick Ratio Changes Over Time
- Stage 1—Pure growth. In these early months there is just new MRR each month. Customers are either still evaluating the product, or are locked in to long-term contracts so no churn occurs.
- Quick Ratio: Infinite. With no churn there is no denominator for the ratio. The Quick Ratio is irrelevant during these months.
- Stage 2—Churn starts. As some customers start cancelling the service, keeping growth at a maximum becomes more important to retain significant MRR coming into the company and maintaining momentum.
- Quick Ratio: Double digits. With the presence of churn, the denominator comes into the equation and a Quick Ratio can start to be calculated. However, as the number of possible churning customers is still low, the Quick Ratio will be artificially high with growth strongly outpacing churn.
- Stage 3—Upgrades and Downgrades. Now the real work begins. As the initial cohorts start to cancel and downgrade, churn becomes more of an issue. Controlling this churn while still driving growth becomes the key to continual, positive net new MRR.
- Quick Ratio: Single digits. As churn inevitably increases, a corresponding increase in expansion or new MRR is needed to maintain a high Quick Ratio. Your Quick Ratio during this stage is a good indicator of the growth efficiency in your company.
When the Quick Ratio is low, it means that churn is likely to be a significant problem in relation to the amount of revenue you’re bringing in. If you are in a growth phase early on in the start-up process this might not seem like an issue, but retention is king. Customer acquisition suffers from declining rates of return as you scale—you find it harder and harder, and more expensive to acquire new customers. Churn, however, is a constant throughout a SaaS company’s lifecycle.
Even with a successful SaaS, churn will stay as a constant percentage of your MRR, while avenues shrink for possible new or upgrading MRR. Because of this, constantly fighting to decrease churn and not relying on more and more customers to keep growth high is a necessity. The Quick Ratio allows you to see, at a glance, how these 2 numbers stack up against each other and whether you have a successful, sustainable business model.