The SaaS environment has reinvented a lot of things. How you approach finance and accounting is one of them. As new concepts and business models emerge, traditional accounting principles won’t cut it anymore. Modern software services ditched the widely used ‘pay once, buy once’ method to adopt more convenient payment systems.
These new subscription-based options are more client-oriented. Service tiers, extra services, and special discounts are but a few examples of how far SaaS accounting and finance models have diverged from classic ones.
SaaS business operations differ from each other, even within the same industry. Software-as-a-service companies manifest the individualistic approach to business. SaaS caters to a range of needs, thus making it almost impossible to mold into defined shapes.
This shift hasn’t been easy to adopt for a few other reasons, as well:
- Even SaaS evangelists and experts are having a hard time defining some concepts and their relations
- It’s hard to fit poorly-defined notions into the classic, clear-cut accounting system
- Some terms are novel and challenging to grasp
SaaS is different, for sure, but embracing change is exciting. That’s what we did below. We made a brave attempt to put together a friendly and easily-digestible guide to SaaS finance.
We describe 7 essential metrics, explore their relationships, and suggest some examples.
Annual Recurring Revenue (ARR)
ARR is the substitute for revenue for a subscription-based SaaS business. Putting together the following stats gives you the annual recurring revenue formula:
- New subscriptions
- Churned revenue
Among these, contractions and churned revenue have a negative value, so the ARR formula looks like this:
New subscriptions + Expansions – Contractions – Churned revenue = ARR
This metric is the predictable revenue that comes from long-term subscriptions, accounted for as a yearly value. In general, you can use any period length to calculate ARR.
One way to do that is to use the monthly recurring revenue (MRR): ARR = MRRx12. If you happen to track quarterly recurring revenue, multiply it by 4 to get the number.
As a recurring value, the metric excludes any one-time onboarding, training, and implementation fees.
ARR provides a bird’s-eye view of your company. Using the annual recurring revenue as a guideline, you can find out more about your pricing strategy and business model. It’s an essential financial metric for forecasting, resource, and cash flow management.
Cost of Goods Sold (COGS)
COGS is the expense category that comes on top of the income statement. It’s the first thing you subtract from the total revenue. Traditionally, it contains all the direct material and labor costs that go into the product. With tangible goods, it’s easy to determine, but SaaS blurs the lines a little.
The general rule of thumb is to ask: ‘Would the product still exist if this cost didn’t?’ Here are a few distinct categories to include:
- Software hosting
Hosting is the environment where the product operates and from where it’s accessible for customers.
- Third-party software licensing
These are the apps that a customer can access in your product. Financial apps in food delivery software are an excellent example.
- Product-related employee expenses
- Server specialists
- Datacenter employees
- Customer care agents (support)
- Account managers (this is a controversial one)
- Implementation and consulting specialists (also controversial)
Below are some expense subcategories not to include:
- Sales-related expenses
- Cross- or up-selling
- Sales commissions and fees
- Third-party apps for internal use
These applications only serve the day-to-day of the departments and administration.
- Product development costs
Anything related to research and development remains in the R&D expense category.
The typical COGS benchmark is around 10-20% of revenue. Those SaaS companies that boast of having achieved the cost of goods sold below 10% are most probably missing a significant expense from the list. They need to go back and review the category. Neglecting this issue can hurt overall business and diminish its efficiency in the long run.
COGS is an essential value for a company’s health and performance. It can also reveal a lot about the business’s profitability, valuation, and scalability.
Gross Merchandise Volume (GMV)
This financial metric is unique for peer-to-peer e-commerce sites. It shows the volume of sold goods and indicates the overall activity on the platform. Although GMV is not a SaaS metric, it is commonly used by SaaS enabled marketplaces or market networks wich describes how good or bad the activity of the marketplace is rolling out during the days or months.
GMV is also useful for identifying and comparing revenues across periods. Still, it’s a raw metric and doesn’t show too much insight into the individual sold item values.
Customer-to-customer (C2C) retailers may or may not be the producer of the goods sold on their platforms. Most of them are intermediaries that facilitate product distribution and receive a commission. In this case, they never actually own the product on sale. Still, they need some type of statistical data for future reference. GMV is what they use.
Professional retailers usually do some marketing and advertising to make the product visible to the potential buyer. Gross merchandise volume calculation includes all these fees and expenses.
Bookings is a primary business growth stat. It helps executives and owners put a number value on the target audience’s interest in the product.
Booking is a unique state in a subscription-based company, where the customer shows a commitment to use the product. Suppose a user confirmed a yearly subscription. However, at this point, they neither paid for nor received the full service.
Bookings is a convenient metric to calculate the potential revenue for startups. It’s an excellent way of exploring the market and positioning the business.
For example, a six-month sales deal initiated in May is a valid booking until the end of December. There are still payments for the coming months and services to be received until the end of the period.
There are a few types of bookings worth mentioning:
- New bookings
This category has two sub-types: bookings generated by new customers and a new service purchased by an existing user.
- Upgrades and expansions
These are the bookings generated by tier upgrades or extra features within the service.
In this category, an old customer re-applies for a service or subscription tier after a previous contract.
- ACV/TCV bookings
ACV bookings take the multi-year contract and account for only one-year revenue. TCV bookings use the whole length of the agreement to derive the value.
Some companies group one-time fees like training and onboarding under this category.
Annual Contract Value (ACV)
ACV is the dollar amount on the average customer contract, normalized for one year. Some experts don’t agree on this metric’s definition and usefulness. Still, we believe it can tell you a lot when combined with other SaaS metrics like churn and customer acquisition cost (CAC).
You can account for ACV per customer per year. You can also find the yearly average contract value for all the clients. Below are formulae for both:
Total contract value / Years in contract = Annual contract value (ACV)
Sum (All customer contracts in a year) / Number of customers = Annual contract value (as an average)
SaaS companies vary a lot (size, industry, and business model, to name a few). Thus, having an industry-accepted benchmark is impossible. ACV is unique for every business model and industry.
Having low or high ACV means nothing unless you combine it with CAC or the total number of customers. Businesses with lower annual contract values usually have lower acquisition costs and more customers. On the other end of the spectrum, high-ACV companies have fewer customers that are pricier to acquire.
You’ll find this concept in a blog post by an angel investor Christoph Janz. Here, the author explains how the average revenue from a client relates to the number of clients.
Including one-time fees in ACV calculation is also quite common. This arrangement can make the product pricier for the first year compared to the next ones.
Besides being useful for business model improvement, ACV is a primary indicator of customer relationship state. You can use it to measure sales, revenue retention, and customer success.
Billings is a crucial financial metric that determines cash flow. It’s the amount due for the given period, as indicated on an invoice.
Most subscription companies use the automated billing method. You attach a payment option to the service (credit or debit card, a PayPal account, etc.) and receive uninterrupted service.
Without stable billings, your business would lose its vital driving force, the cash flow. You also need to find a way to bill customers upfront. It’s essential because of the scalable nature of SaaS businesses. Some free cash on hand will cushion your business in case of rapid growth.
During the billings calculation, keep an eye on the period and the amount paid.
If you’re here, you probably know what revenue is. Still, subscription-based SaaS models place specific requirements on this general accounting principle, too. A couple of sections back, we established that bookings are contracts with all or part of them still hanging in the air. Let’s see how they differ from actual revenue.
Bookings are simple commitments. While they are nice to have, they aren’t very reliable for making decisions about the future. Using revenue as a reference point is always more accurate.
When the customer receives the service and pays for it, the booking turns into revenue. Take a yearly booking with a monthly payment. At the beginning/end of every month, the contract’s 1/12 part transforms until the contract expires.
Two main revenue types exist: recognized or deferred. Recognized revenue is when the bookings are followed through on time and by both parties. These also contribute to the cash flow within a given period.
Deferred revenue is the payments you haven’t yet recognized. In other words, you’ve received the charge for a service you haven’t delivered. This might sound horrible, but usually, it isn’t. The deferred revenue can accumulate as a result of upfront payments for long-term deals. If the contract hasn’t expired yet, a part of the service will always be up for delivery.
The only way this type of liability can cause problems is if you don’t treat the recognized and deferred revenues separately.
All described metrics are crucial for the financial success of a SaaS business. Each gives you valuable insight into the present, future, and development possibilities for your organization. Combined, they are even more powerful.
You might argue that SaaS is disrupting the way you approached accounting. However, once you grasp the notions and set up the right system, things will get easier.
Forecast your growth with the help of ACV and optimize the COGS to reach high-precision operations. Track the bookings to get excited about your goals and keep an eye on billings to make sure they follow through. Finally, review your revenue and make sure you’re ready for more.
SaaS accounting isn’t a passive bookkeeping method. It’s a strong basis for a company’s health and growth. If done right, it gives you a glimpse into the future.