Financial ratios are essential for decision-making in every SaaS company.
An essential ratio for SaaS companies is the acid-test ratio and is commonly referred to as the quick ratio. In this article, we will take you through what the acid test ratio is, the acid test formula, how to calculate it, and more!
True to its name, the acid-test ratio is easily and quickly calculable, especially using the Baremetrics integration.
Baremetrics is a business metrics tool that provides 26+ metrics about your business, such as MRR, ARR, LTV, and more. Baremetrics integrates directly with your payment gateways, allowing you to view financial data in real-time via smart dashboards. Start your free trial today.
What is the Acid Test Ratio?
When considering finances in your SaaS company, it’s necessary to consider what your current assets and liabilities are. These two variables can cause the most anxiety in every balance sheet as they fluctuate month to month.
What are the assets currently valued at? Can we continue running with our current liabilities? Can we pay off any short-term debts comfortably?
These questions are quickly answered by the acid test ratio. What exactly makes up this ratio? Here are the variables:
- cash equivalents
- short-term investments
- accounts receivable
- current liabilities
Between the cash or cash equivalents and any other easy-to-liquidate current assets that your company has, all current liabilities (especially short-term debt) should be quickly settled if your company’s growth is in the right direction.
Staring at the balance sheet all day will not yield the right information for your decision-making, but using the correct formula and specified variables can get you there quickly. Let’s dive into what the acid test ratio is and how to use it in your business.
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What is the Acid Test Ratio Formula and how do you calculate it?
Now we know what makes up the acid test ratio, it’s time to apply the formula below:
Acid Test Ratio = (cash + cash equivalents + short-term investments + accounts receivable) / current liabilities
What is the Acid Test Ratio for SaaS companies?
If you're a SaaS company, you work hard to develop marketing strategies, lead generation, and nurturing sequences that finally land you new customers only to see that your monthly revenue growth is slipping due to downgrades or churn.
Enter the Acid Test Ratio!
This ratio is beneficial for calculating the movement of your growth (by subscriptions or other membership plans/bookings). For a SaaS company, the Acid Test Ratio or Quick Ratio is calculated slightly differently than the generic formula detailed earlier in this article.
The SaaS Acid Test Ratio shows the net inflow and outflow of the monthly recurring revenue (MRR) or annual recurring revenue (ARR) of your SaaS business.
The SaaS Acid Test Ratio Formula:
SaaS Quick ratio = (New MRR + Expansion MRR + Reactivation MRR) / (Contraction MRR + Churned MRR)
Let’s walk through an example to make more sense of the Acid Test Ratio for SaaS. The table below contains the numbers for Company M’s monthly tracking of new and expanded bookings, churn, and downgrades.
You can see that the formula contains MRR instead of bookings. Depending on your company’s preferred metric (MRR, ARR, or bookings), the values can be easily adjusted and the correct numbers inputted. If your company prioritizes ARR over another metric, you can easily switch MRR for ARR without recognized revenue. MRR typically includes bookings and recognized revenue. Company M uses bookings; thus, the Acid Test Ratio can be adjusted to the formula below:
Company M Acid Test Ratio = New Bookings + Expansion Bookings ÷ Churn + Downgraded.
With this formula, the essence of the calculation is maintained, which is growth divided by contraction.
Company M’s Acid Test Ratio stands at the current value:
$200K + $150k ÷ $70K + $20K = 3.8
Can SaaS companies apply the Acid Test Ratio?
A random entrepreneur looking at the Acid Test Ratio value calculated in the previous section may find that it holds no information they can understand.
However, for a SaaS company executive, especially someone from an example like Company M, this number can give valuable insights in making future decisions.
The SaaS Acid Test Ratio can signal different situations. Here are three places you’ll typically find a SaaS company in following your acid test ratio:
1. Acid Test Ratio < 1
This means that your SaaS company is in a bad place. Your company can last a month or two as it is, but any further and the churn and contraction rates will bury your company.
2. Acid Test Ratio > 1 and < 4
This means that your company is growing, but slowly. The slow growth could be because you’ll need to keep customer acquisition (and retention) efforts at high levels to replace lost or churned bookings or MRR.
3. Acid Test Ratio > 4
This means that the direction of growth is excellent and efficient. Generally speaking, it can be seen that for every $1 lost in revenue, $4 is earned back.
Utilize Acid Test Ratio with Baremetrics
With the SaaS Acid Test Ratio at your fingertips, it becomes easy to know what angles of your business require urgent attention or sustained efforts in the same direction.
It may be difficult to pull the values you need to compute the SaaS Acid Test Ratio yourself. Integrating smart tools that track these monthly metrics is the most efficient way to go.
This is where Baremetrics comes in.
Growing SaaS and subscription businesses use Baremetrics to gain actionable insights from their financial data.
Start a free trial of Baremetrics today, and keep this financial ratio handy when looking at your subscription revenue.