In our previous two posts, we dove into calculating two important financial KPI metrics, Customer Lifetime Value, and Customer Acquisition Costs. If you look at CAC and LTV on their own, however, they don’t necessarily tell you the whole story. For example, if the LTV of your average client is $1,000,000, that sounds like things are clearly going well. But if you spend $2,000,000 acquiring them then you’re underwater! This is where the LTV:CAC Ratio comes into play.
Calculating The LTV:CAC Ratio
One of the best barometers to analyze the efficiency of your sales and marketing output and how well you monetize customers is the LTV:CAC Ratio. Spending lots of money to acquire unprofitable customers is a recipe for disaster. So let’s dig in.
Using the same methodology to calculate CAC and LTV from our previous posts, let’s use some hypothetical financial data for a SaaS business to calculate our LTV/CAC ratio:
LTV:CAC Ratio Benchmarks
So based on this example, our LTV:CAC ratio is 3 to 1. But what does that tell us?
Since we used gross margin in our calculation for LTV, it means that for every dollar you spend on customer acquisition costs, you’re earning back $3 in gross margin on that customer. Keep in mind, that this only takes into account your sales and marketing costs (and the cost of goods sold) to give you a good measure of how your “sales and marketing engine” is performing. Put a dollar in and get $3 out. LTV:CAC is not necessarily saying that your business is profitable, however, since it doesn’t take into account operating expenses.
So when looking at the LTV:CAC ratio, there are a few benchmarks that give you a sense for how efficiently your customer acquisition and retention strategies are working:
Putting it All Together
While these are good benchmarks, your LTV:CAC ratio should be reference points used in conjunction with other data. For example, while a 5:1 ratio likely means you are missing an opportunity to acquire customers faster. If topline revenue is exploding and operations are struggling to keep up, growing that fast might actually sink the business.
As a sales efficiency and growth metric, LTV:CAC is a great indicator of how well you acquire customers. It doesn’t necessarily tell you how well the business is operating as a whole since it doesn’t take into account operating costs, product development costs, and other expenses in the calculation. However, if you can’t acquire customers profitably there’s likely no business to begin with. One exception to this is venture-backed companies. Venture capital can offset unprofitable acquisition costs in the short and mid-term. However, the strategy there is typically hyper growth at all costs to create network effects and scale. So not for everyone! It really all depends on your business model and how you want to grow your business.
Customer acquisition costs, lifetime value, and the LTV:CAC ratio are three important metrics that all businesses should utilize. Compass East takes a bottom-up approach to create the financial infrastructure needed to quickly capture the financial data to calculate KPIs like LTV and CAC for our clients. These metrics are the outputs, but a significant amount of work needs to happen to capture the inputs. Reach out with any questions or to learn more about our process in making KPI dashboards a reality!
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