Capital Efficiency: Why and how to calculate it

Capital efficiency is an umbrella term used to describe how efficiently your company uses its invested capital to generate revenue.

Suppose your company spends $1 to generate $1. In that case, your company will have a capital efficiency ratio of 1:1. The higher the ratio, the more efficient a company is at optimizing capital expenditure and attaining revenue growth.

Businesses can use various Capital Efficiency Metrics to track and improve their performance. The metrics a company uses will depend on its business model and maturity. 

Read on to know more!

How do you measure capital efficiency? 

Tracking the capital efficiency of your SaaS company will help you realize your position in the current marketplace.

Some of the commonly used capital efficiency metrics include:

  • Cash Conversion score 
  • Burn Multiple
  • Return on Capital efficiency (ROCE)
  • Bessemer's efficiency score 

Efficiency-Oriented Metrics for SaaS Startups:

A SaaS startup should analyze its capital efficiency. There are various formulae available. We've listed some below

  • Sales Efficiency (otherwise known as the SaaS Magic Number)
  • Human Capital Efficiency
  • Capital Efficiency Ratio 
  • Burn Multiple
  • Besser Efficiency Score
  • Return On Capital Employed
  • Cash Conversion Score

Let us dive deeper into them! 

Sales Efficiency:

Measuring the sales efficiency of your SaaS startup is easier than ever with this tool. You can calculate the sales efficiency as New ARR (Annual Recurring Revenue) created in the current quarter, divided by the prior's quarter sales and marketing expenses. When measuring sales and marketing efficiency, you will find no better option. 

Rule of Thumb? Industry specialists believe that a sales efficiency of 1.0 indicates that your sales strategy works perfectly and efficiently. The higher the score, the better! 

Human Capital Efficiency:

Generating and sustaining ARR using human capital will reflect human capital efficiency in your startup. If your company takes more human capital to generate and sustain ARR, you must rethink and remodel your human capital strategies. 

Human capital efficiency can be calculated as follows:

                                           Total ARR/Total Full Time Equivalents (FTEs) 

If more human capital generates and sustain your ARR, your firm is said to be less efficient. 

Capital Efficiency Ratio

The Capital efficiency ratio determines how much growing revenue a company has spent and how much it has received in return. Measuring the company's effectiveness in generating ARR will help you realize how much ARR your SaaS needs for the year (financial cycle). 

The capital efficiency ratio is calculated as:

                                           Total Equity + Total Debt - Cash/ARR

A lower capital efficiency ratio is better since it reflects the broadest measure of your SaaS effectiveness. 

The Burn Multiple Metric:

David Sacks of Craft Venture coined the term "Burn Multiple" . The term expresses how much cash a company needs (A SaaS company in this case) to burn for generating every new dollar of the annual recurring revenue. The burn multiple metric reflects the skills and abilities of a startup at generating growth and revenue. 

The burn multiple ratio of your startup will reflect your burn rate compared with its ARR growth. Here is how you can calculate it:

                                    Burn Multiple = Net Burn/Net New ARR

Burn multiple is a great indicator to see whether your startup is capital efficient. It shows you the relationship between your capital expenditures and business growth. If your startup spends fewer dollars than its new ARR, your company is said to be capital efficient. 

For instance, if your company burns $0.65 to generate $1 of the new ARR, your firm is said to be capital efficient. However, if your company spends $2 to generate $1, it tells you that you have to make a few changes.

Bessemer Efficiency Score:

If you are interested in tracking the net new ARR against your burn score, the Bessemer efficiency score can help you. It is a capital efficiency indicator that tracks the net new ARR against every dollar burnt for a given period. This measure of capital efficiency was created by Bessemer Venture Partners. The formula is as follows:

                                    The sum of Net New ARR/Sum(Net Burn)

The higher the Bessemer efficiency score, the better the company's capital efficiency. 

What is a good Bessemer efficiency benchmark?

 According to Bessemer Venture Partners, the ideal Bessemer efficiency score is greater than 1.5x.

The ideal range for the Bessemer efficiency benchmark is 0.5 -1.5, and your company should achieve these standards for better financial performance. A BVPES score of 0.5x or less is considered good, 0.5x - 1.5x is considered better, and something above 1.5x is considered best. 

Investors who want an objective way of looking at capital efficiency will use this metric. It can help you realize and understand your capital efficiency and make positive changes when needed. 

Return on Capital Efficiency (ROCE):

 ROCE is another popular metric expressing your SaaS startup's performance since it focuses on net profit. The formula to calculate return on capital efficiency is given here:

            ROCE = Earnings before interest and taxes (EBIT)/Capital employed

The total capital employed includes total assets - current liabilities. 

If your ROCE score is high, it indicates you are doing well in terms of return on capital employed. Moreover, you can also gauge your standing in the market by comparing your ROCE to your competitors'.

As a general rule, the higher the return from capital employed (ROCE), the better it is for your company. The ROCE calculation shows how much profit an organization produces for every dollar of capital utilized. The higher the number (which is denoted as a percentage), the better a company is performing.

One method for determining whether your company has a decent return on capital employed (ROCE) is to benchmark capital efficiency with those of different companies in a similar area or industry.

Another method for deciding whether your company has a decent ROCE is to compare it with your previous years' ROCE. If your ROCE has been declining, it implies that your company's productivity levels are declining. On the other hand, If that ROCE is increasing, this implies that your company's profit is increasing. 

 Cash Conversion Score:

You need to know how much revenue your company generates for every dollar spent. A cash conversion score is another excellent metric to illustrate your company's financial health. It offers the most forward-thinking solution that you must optimize for better results. Cash conversion is calculated as follows:

 Cash Conversion Score = Current ARR/Total capital raised to date - Cash on the balance sheet.

Bessemer Venture Partners have set the benchmark for cash conversion scores to assess a company's future success and performance. 

Why capital efficiency matters for SaaS startups?

The industry is already growing fast, and with this pace comes competition for SaaS companies.

Venture capitalists will never invest in a startup that lacks a profitable growth trajectory. Therefore, it is crucial for startups to come up to focus on capital efficiency. Capital efficiency can help you position your firm as a solid bet for investors - especially VCs.

Here are a few advantages of capital efficiency for SaaS startups:

  • Sustains growth 
  • Generates more investment and therefore more capital
  • Extends Runway
  • Portrays financial picture 

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