The LTV/CAC Ratio is a key performance indicator (KPI) that measures the relationship between the lifetime value of a customer (LTV) and the cost of acquiring that customer (CAC). The LTV/CAC Ratio helps SaaS companies understand the effectiveness of their sales and marketing efforts and make informed decisions about resource allocation. Here are the most important facts about the LTV/CAC Ratio.
How to calculate LTV/CAC Ratio
The LTV/CAC Ratio is calculated by dividing the customer’s lifetime value by the cost of acquiring that customer. For example, if a customer’s LTV is $10,000 and the cost of acquiring that customer (CAC) is $2,000, the LTV/CAC Ratio for that specific customer would be 5:1.
In practice, the LTV of all new customers in a period is compared with the customer acquisition costs incurred in this period (or in the previous period in the case of longer sales cycles at specific SaaS businesses).
Let’s quickly break down these concepts and understand how to interpret the LTV/CAC ratio.
- Customer Lifetime Value (CLTV)
It measures the net revenue a business can expect to generate from a customer over their entire relationship with the company. It takes into account factors such as the customer’s average subscription duration, MRR/ARR, upsells, cross-sells, and customer churn rate. LTV helps to estimate the long-term revenue potential of a customer. - Customer Acquisition Cost (CAC)
CAC is the cost incurred by a company to acquire a new customer. It includes expenses related to marketing & sales which are involved in attracting and converting leads into paying customers. CAC helps determine how much a company needs to invest to acquire each customer.
You can find more information on the calculation here: CLTV & CAC
LTV/CAC Ratios and how to interpret them
The LTV/CAC ratio compares the value a customer brings to the business (LTV) against the cost of acquiring that customer (CAC). This ratio is an indicator of the efficiency and profitability of a company’s customer acquisition and retention efforts. Here’s how to interpret different LTV/CAC ratios:
- LTV/CAC Ratio > 3
A ratio higher than 3 indicates a healthy customer acquisition strategy. It suggests that the expected revenue from a customer is at least three times higher than the cost incurred to acquire them. This indicates a high potential for profitability and a positive return on investment (ROI) from customer acquisition efforts. - LTV/CAC Ratio 1 – 3
A ratio between 1 and 3 implies that the company’s customer acquisition strategy is moderately effective. While the revenue generated from each customer is greater than the acquisition cost, it may not be sufficient to achieve high profitability. It’s important to closely monitor customer retention rates and ensure efforts are made to increase customer lifetime value. - LTV/CAC Ratio < 1
A ratio lower than 1 indicates that the company’s customer acquisition strategy is inefficient and unprofitable. The cost of acquiring customers is higher than the revenue generated from them over their lifetime. This situation is unsustainable in the long run and calls for a shift in the company’s strategy in marketing, sales, and customer retention strategies.
Several factors can influence the LTV/CAC Ratio, such as the length of customer contracts, the average revenue generated per customer, and the cost of sales and marketing efforts. For example, a company that has longer contract lengths and higher revenue per customer may have a higher LTV/CAC Ratio than a company with shorter contract lengths and lower revenue per customer.
In summary, the LTV/CAC Ratio is a key performance indicator that measures the relationship between the lifetime value of a customer and the cost of acquiring that customer. A healthy ratio is generally considered to be 3:1 or higher, indicating that the company has a scalable business model. Interpreting the ratio requires to consider several factors that impact customer acquisition costs and lifetime value.