If you're wondering about the true value of your ideal customers and what it means to your SaaS business model, you can easily find answers to your questions by measuring the LTV/CAC ratio.
The LTV-CAC metric tells you if the overall revenue you gain from your existing customer base makes up for the effort, time, and especially money you put into acquiring them.
Today, in this article, you will learn about this ratio, its components, and how to calculate them separately and combine them to help you understand your own business better, thus coming up with more relevant decisions regarding its future and growth potential.
As the name suggests, the LTV/CAC ratio consists of two separate SaaS metrics. Before moving on to the ratio itself, we need to learn what each metric in this formula is and how they're calculated.
Let's see what they are, what they help us achieve, and understand how to calculate them.
Lifetime Value (LTV)
This metric helps you understand the possible future of your business and lets you have an idea about things like average revenue and profits, and come up with more effective product decisions and effective strategies. It also helps you balance customer acquisition costs (which will be explained later) and understand the marketing expenses you need to make in order to keep your healthy business going.
In order to calculate this metric, you need to multiply the profit per year by the average duration of the profitable business relationship with the client.
And to know the average duration of the relationship, you need to divide the number of your clients by the sum of the total amount of years spent with those clients.
Customer Acquisition Cost (CAC)
The Customer Acquisition Cost is an essential metric that shows the total expenses that are supposed to be made in order to obtain a brand new customer.
It's important to keep in mind that while measuring this indicator, you need to be looking at two separate marketing channels - inbound and outbound- and include all sales commissions in addition to numerous variables, including refunds, chargebacks, and account credits.
This key metric helps you understand and decide whether or not you should balance your marketing and sales expenses -and keep them lowkey- in order to acquire new customers or take a different road and skyrocket them.
To calculate this metric, you need to divide your total marketing and sales expenses by the number of your new clients.
What is the LTV/CAC ratio?
The LTV/CAC ratio is an essential metric that indicates the comparison between a customer's average lifetime value and the total amount of money spent on acquiring them.
📌 Put differently, this e-commerce indicator helps you understand and compare the new customer's value over their overall lifetime in relation to the marketing cost of making it all happen, thus coming up with relevant business decisions and taking further action accordingly.
What does LTV/CAC tell us?
1- It creates a focus on business expenses.
The LTV/CAC ratio pinpoints the exact amount of money you're spending on your services, including customer service, sales, and marketing. This creates an opportunity to get familiar with your customers' exact worth to your company and thus lets you put all your retention efforts and marketing spends into the relevant and, most importantly, deserving area of focus.
2- It helps you lower the overall Customer Acquisition Cost.
The thing about this ratio is that it significantly helps you shape your business strategies and re-think all your processes in order to lower your CAC and boost the profits as a natural result of wise marketing investments. By balancing your LTV/CAC ratio, you can avoid big mistakes like blindly wasting money for the sake of marketing campaigns or simply missing out on opportunities and wasting resources.
3- It lets you know when you are not spending enough. Or the exact contrary.
This means that the amount of money you're spending on gaining a new client -CAC- is more or less three times less than the LTV.
A higher LTV/CAC means you are risking too much by spending more than you ought to. And a lower LTV/CAC means that chances are you're playing too safe and not spending enough money to help you get profitable opportunities.
How is LTV/CAC calculated?
Once you have your Customer Lifetime Value and the Customer Acquisition Cost calculated separately, as mentioned above, all you need to do is divide the former by the latter.
Let's give an example of an ideal LTV/CAC ratio for a better and deep understanding:
Let's say your company's Customer Lifetime Value is $1,500, and the total amount of sales costs made to acquire a new client is $500, then your LTV/CAC ratio would be 3/1, which indicates that whatever you're doing is working smoothly and you do not need to make dramatic changes regarding your numbers.
On the other hand, if your LTV is $4000 and your CAC is $1000, then your LTV/CAC ratio would be 4:1, which may indicate a bigger growth opportunity and encourage you to consider increasing your marketing efforts and expenses.
Benchmarks - what is a good LTV to CAC ratio?
Depending on the scope of your product and the type of industry you're business is operating in, the LTV/CAC ratio can change and become ''perfect'' with different numbers. And this is why you need to consider a number of things to ensure that the accurate benchmark you're using to measure your ratio is the ''one'' for you.
Less than 3:1
If your ratio is less than 3/1, it means you're risking too much. There's a likelihood that if it gets below 1/1, then that means the value you gain from your acquired customer is not worth what they cost you to acquire them in the beginning.
Put differently, the future of your business is not very hopeful, and this will obviously not help you attract potential investors.
This ratio, being not too high or too low, is ideal enough. This exact point will bring you satisfied investors, a balanced customer lifespan, and customer acquisition costs in addition to customer acquisition strategies and long-term business plans. If you manage to get this balance right, you can easily take your time to pay more attention to things like product development, further long-term growth plans, strategy making, etc.
Higher than 3:1
It may sound like a ratio of 6/1 or 9/1 would be better than a 3/1, but in a SaaS sense, those ratios would indicate a bunch of missed growth opportunities and great business decisions. Meaning, you might be restraining your growth processes and spending too little, thus giving your competitors a big advantage in the market.
Quick Tips to Improve Your LTV/CAC Ratio
The best and most efficient way to improve your LTV/CAC ratio is to improve its components separately.
- Avoid the possibility of early customer churns with the help of great onboarding.
- Two words. Customer Retention. Remember to retain your clients with the help of great customer experience and brilliant customer service.
- To boost the value of a customer, make sure your sales and marketing teams are paying enough attention to upsells and cross-sells.
- Aim for product stickiness.
- Take customer feedback into consideration. They're the most valuable piece of information that reveals the exact requirements of your existing customer base.
- Pay extra attention to your highest converting channels, both sales, and marketing.
- Meanwhile, keep tracking not-so-well-performing channels as well. Improve or eliminate.
- Be confident about your sales process and your sales team and make sure they're working as efficiently as possible.
The world is changing rapidly, and so is the SaaS world. If you want to make sure your business stays on track and becomes profitable at all costs, you need to keep track of what matters. By measuring this ratio, you can save the time, effort, and money that otherwise would be wasted on irrelevant and unnecessary business decisions or missed opportunities.
So yes, it might seem complicated at first, but it is essential for the future success of your business, so you should get started already!