An underlying point you should consider is that this metric is best used to define revenue growth in the startup or early growth stages of a SaaS business. You'll understand why going further into the article.
Also, the SaaS quick ratio is not to be confused with the identically-named finance concept - quick ratio, aka acid test ratio. The acid test ratio is an accounting principle that measures liquidity - a company's ability to pay off current liabilities at a given point in time. However, both metrics measure the same aspect - whether a business's revenue health is good or poor.
The formula is pretty straightforward: the measure of net monthly revenue inflow (MRR growth) by the revenue outflow (lost MRR).
SaaS Quick Ratio = (New MRR + Expansion MRR) / (Churned MRR + Contraction MRR)
Monthly Recurring Revenue (MRR): The predictable recurring revenue earned from subscriptions in a particular month. (MRR * 12 = ARR)
New MRR: The revenue your business makes from all the new customers gained during a month.
Expansion MRR: The additional MRR from all customers who have upgraded to a higher pricing plan from a lower-priced plan or purchased a recurring add-on, including MRR contribution from reactivation of a previously canceled subscription and free-to-paid conversions.
Churned MRR (or Cancellation MRR): (A component of Contraction MRR) The MRR lost due to canceled or churned subscriptions.
Contraction MRR: The MRR lost due to cancellations, downgrades to lower price plans, removal of recurring add-ons, or even because of availing discounts.
Company A: $6000 (New + Expansion) / $1000 (Contraction + Churn) = Quick Ratio 6
Company B: $7500 / $2500 = Quick Ratio 3
Company C: $10000 / $5000 = Quick Ratio 2
Company D: $25000 / $20000 = Quick Ratio 1.25
The Net New MRR is $5000 (new+expansion - contraction+churn) in all scenarios in the above examples. Yet, Company A fairs better than the rest since it makes that revenue with much less effort than the other companies. (To further explain: Company A makes $6 for every $1 lost whereas Company D makes $1.25 for every $1 lost, which is only a $0.25 gain. When the contraction is almost the same as expansion, it takes more effort to improve revenue health). Hence, the higher the quick ratio is, the better.
When venture capitalist Mamoon Hamid, partner and co-founder of Social+Capital, coined the metric, he also came up with the hypothesis that a quick ratio of 4 and above was a company worth investing in. Given that VCs like Hamid were using the quick ratio to aid their investment decisions (Hamid funded companies like Slack, Box, Yammer), it quickly became a benchmark. Many SaaS startups began using it as a pitch in their presentations.
However, this ratio might be more appropriate for measuring revenue growth in early-stage companies vs. scaling or mature companies. Here is the reason why:
A quick ratio of 4 means $4 of the revenue made for every $1 lost. This kind of exponential growth is seen in the early phases and cools down as a company grows. Moreover, the likelihood of churn also increases. This is not to say that scaling or mature businesses shouldn't measure the quick ratio. But the fact remains that the difficulty of gaining 4x revenue for every unit churn is exceptionally high and only keeps growing as the company does. Scaling or mature SaaS companies rarely manage that.
Additionally, the difference between a quick ratio of 4 for early-stage companies and scaling or mature companies is that we are talking about phenomenal growth; in contrast, for the latter, the focus is on phenomenal-ly low churn rates.
So, as per conventional standards, a quick ratio of 4 is considered healthy, and by all means, a high quick ratio is what you should be aiming for. But having a lower quick ratio doesn't necessarily scream danger; it is very subjective to the business's scale. The quick ratio by itself can't be the sole determinant of a company's growth efficiency. It should be looked at in conjunction with CAC (customer acquisition cost) and LTV (customer lifetime value) to get a more wholesome understanding. (To further explain: For some companies, CAC might be a lot more or a lot less than the industry average. In such cases, high MRRs might not look so great against an almost as high marketing spend. In-kind, some companies choose to pay more attention to LTV compared to one-time purchases. In such cases, a low quick ratio is not an issue since you are aware that it will take time to scale it up. With aspects like these in consideration, it isn’t enough to base growth efficiency on just one metric. Moreover, no SaaS metric exists in complete isolation. Metrics need to be looked at in conjunction to get a holistic view of your business.
For any business, the go-to strategy while starting is to acquire as many customers as possible. The focus, however, should switch over time from gaining new customers to your existing customers, retention, and more importantly - reducing churn; the mantra for any company aiming for high growth rates should be to aim for low churn rates.
Additionally, your strategies should depend on what your quick ratio shows you. Is there a lot of churn? Focus on retention. Is there not much expansion? Focus on product stickiness and customer experience. Based on your understanding of the components that make your formula, you can pick and choose ways to improve your quick ratio.
Among SaaS metrics, the quick ratio is quite insightful. As much as you love to see your company's growth rate go through the roof, you also want to know how it is happening - because of new revenue or low churn - and the quick ratio gives you a peek into this. Like we discussed above, there are several ways for you to leverage those insights to your benefit. Finally, regardless of the myriad of opinions on an 'ideal' quick ratio, on any day - the higher the ratio, the better. Hence, the aim should be to improve it continually.