SaaS Financial Model

What are SaaS Financial Models?

SaaS financial models are forecasting tools software companies use to project future financial performance. They’re based on historical business performance, market dynamics, and assumptions about future growth.

When you’re building a financial model, there are three primary things it should tell you about your SaaS company:

• Revenue drivers — Financial modeling shows you which products and business activities drive the highest growth or show the highest potential for your company. Examples include upselling, webinar attendance, and features customers seem to show preference for.
• Financial milestones — Your SaaS financial model will provide sequenced targets for you to aim at. You can use them to set sales quotas, communicate future value to investors, and plan for sustainable growth.
• Company structure — Using the results of financial modeling, you’ll be able to deduce the optimal structure for your SaaS business. This includes finding out which departments should be scaled up, downsized, and outsourced.

As a SaaS startup, a financial model should help you understand how fast you’ll be able to grow and through which channels, whether to be aggressive or conservative with pricing and product development, how much money you have to raise (if any), and how to manage your cash flow.

Synonyms

• SaaS forecasting
• SaaS revenue model

Importance of Financial Modeling for SaaS Businesses

Financial Forecasting

The main reason you’d use a financial model is to create financial forecasts. Particularly as a smaller company, making tough investment decisions is a bit like throwing darts with a blindfold and hoping to hit a bullseye. A financial model allows you to test different scenarios and see what the potential outcomes are before committing to a course of action.

Budgeting for Resources

When you can reasonably expect a certain amount of growth over a certain period, you can begin to answer two questions:

• “What do we need to do to achieve that projected growth?”
• “Based on these figures, how much can we afford to spend on X, Y, and Z?”

When you’re creating a budget, you’ll get the essentials off the table first. Then, you’ll move on to the additional investments required to grow at the projected rate or higher. From there, you can determine budgets for companywide initiatives — marketing, sales, software, etc.

Let’s say you’re doing $1 million MRR and forecasting 50% growth over the next year. Once you know you’ll have $500k in additional revenue, you can determine which strategies will help you reach those goals (e.g., onboarding a new sales rep or doubling down on a successful marketing channel). Those are the areas that will see an increased budget allocation for the next year.

Predict Revenue

SaaS businesses are already at a huge advantage: they use a recurring revenue model.

Assuming they retain their subscribers, they have a reliable, relatively stable source of income. So, it’s relatively easy to compare past growth to the current rate they’re adding new customers and go from there.

That said, several factors impact revenue growth and customer retention rates — competition, market saturation, changing customer preferences, and seasonality to name a few.

Using a financial model to forecast different scenarios and potential outcomes helps you prepare your business for any challenges and opportunities.

Raise Capital from Investors

Investors want to know the potential return on their investment in a SaaS company. And financial health is one of the first things they’ll look at. They’ll use ratios like the Rule Of 40 to value your business based on growth and profit margins.

Financial modeling takes the data a step further. Since they help you figure out how much money you need to raise to achieve a certain level of growth (and prove it algorithmically), using them makes it easier to pitch investors and helps them understand where they’re putting their money. If it earns the company a higher valuation, that means the founders probably won’t have to dilute as much, either.

Financial Reporting

SaaS financial models are based on balance sheets, cash flow statements, and income statements. So, when you create a financial model using those statements, you’re essentially looking at how the company will perform financially over time.

By comparing these reports to actual performance throughout the year, you can identify any discrepancies or areas for improvement. This helps business owners stay on top of their finances and make informed decisions based on real data.

Types of SaaS Financial Models

There are five different financial forecasting models SaaS businesses use. Each takes into account different aspects of the business, such as revenue growth, expenses, and profitability.

Financial Forecasting Model

Financial forecasting models use current company data to make inferences about future financial performance. They consider payroll, operating costs, revenue from customers, and cash flow.

You can either create a top-down or bottom-up financial forecasting model.

Top-Down Forecasting

Top-down forecasting starts with a high-level estimate of market potential (i.e., your total addressable market) and works down to individual customer acquisition.

Consider a SaaS startup targeting the healthcare industry. In a top-down forecast, they’d start by identifying the total addressable market (TAM) — let’s say there are 500,000 potential customers in this sector.

Then, they’d estimate the percentage of this market they could realistically capture, based on factors like their marketing strategy, competition, and product offerings.

If they aim to capture 1% of the TAM in the first year, that’s 5,000 potential customers. They’ll then forecast their revenue based on this customer base, taking into account their pricing structure, expected customer lifetime value (CLV), and customer acquisition cost (CAC).

Bottom-Up Forecasting

Bottom-up forecasting is the opposite of top-down forecasting. It starts with individual teams, customers, and revenue streams and works up to broader market estimates.

Using the same example as before, the SaaS startup would begin by estimating how many sales reps they’ll have on their team (let’s say 10). They’d then forecast each rep’s sales targets based on previous sales data or industry averages. From there, they’ll multiply the total number of sales by the average deal size to get a revenue forecast.

Bottom-up forecasting helps SaaS businesses break down their goals into more manageable, actionable chunks. It also allows them to identify areas for improvement within individual departments or teams.

Operating Expense Model

Operating expense models look primarily at operating costs and how they impact profitability. It’s unique to SaaS financial modeling because SaaS businesses have significantly different overhead costs than other organizations.

In addition to the regular sales, admin, marketing, and support expenses, SaaS orgs also have to consider:

• Server costs. Software products use lots of bandwitdth to run. Every time they onboard a new user or customer, they need to ensure their infrastructure can handle the increase in usage.
• Subscription management. SaaS vendors use a mix between flat-rate, usage-based, and tiered pricing. Each customer uses a different amount of resources, so they need integrated software that handles it automatically.
• Development. Buidling, expanding, and maintaining a SaaS product takes continuous development work, in addition to fixing bugs and responding to customer feedback. And developers are some of the most expensive hires.

The benefit of the operating expense financial model is it helps SaaS companies keep a close eye on their expenses, so they can continue to grow at a healthy rate.

Reporting

Reporting models tell leaders, Board members, and investors about your company’s financial health. To create one, you’ll pull data from three financial statements:

• Balance sheet
• Cash flow statement
• Profit & loss (P&L) statement

Balance sheets show what your company owns and owes. The cash flow statement shows where the money for these assets comes from, and where it gets spent. And P&L statements show revenue, expenses, and profit.

Headcount Planning

Your growing customer base demands greater server bandwidth. That bandwidth, however, gets less and less expensive as you scale your company.

On a per-user basis, software companies earn more money when their user base grows because it costs them less to add additional capacity. So, the faster they grow that user base, the more profitable they’ll be per customer.

A headcount planning financial model can help your SaaS business account for economies of scale, so you can understand how customer growth translates to changes in your margins.

SaaS Financial Metrics

You’ll need to look at key performance indicators and benchmarks to know whether your company is on track or needs to make changes.

From a financial standpoint, here are the most important SaaS metrics to look at:

Recurring Revenue (MRR and ARR)

You can measure your recurring revenue in two ways: MRR and ARR.

• Monthly recurring revenue (MRR) gives you an at-a-glance view of your monthly income. MRR accounts for any upsells, downgrades, new business, or churn that happens from one month to the next.
• Annual recurring revenue (ARR) looks at your yearly earnings instead. It helps you zoom out to see macro trends in financial growth, which are tough to spot looking at monthly figures.

Both are equally important, but you use them for different things. You’d track MRR to evaluate the success of the stepping stones toward your year-end goals (e.g., a marketing campaign). ARR tells you if you’re moving in the right direction year-over-year.

Customer Acquisition Cost (CAC)

Customer acquisition cost (CAC) tells you how much you spend to get a customer. To calculate it, divide all the costs spent on sales and marketing by the number of new customers acquired in that period.

For example, if you spent $50,000 on sales and marketing this month and gained 10 new customers, your average CAC would be $5,000.

Ideally, this number will decrease over time as your SaaS business scales, reaches product-market fit, and converts leads into paying customers more efficiently.

Customer Lifetime Value (CLV)

Customer lifetime value measures the potential profit a customer will generate over their lifetime. It uses your average customer lifetime and average value of that customer as the assumptions to make this calculation.

To calculate CLV, multiply the average revenue per customer by their expected lifespan as a customer.

Payback Period (CAC Payback)

If your CAC is higher than your CLV, you’re losing money on every customer. You’ll obviously spend money upfront to acquire each customer, so your payback period tells you how long you have to retain them to break even.

It’s a simple calculation: divide your CAC by the average revenue per customer.

If it takes you 12 months to earn back the money you spent on acquiring each customer, then your payback period is 12 months.

LTV:CAC Ratio

You’ll want to do more than just retain your customers. Beyond the payback period, you’ll want to look at the ratio between your customer lifetime value and customer acquisition cost.

If you’re breaking even (i.e., dropping customers at the end of the payback period), your LTV:CAC ratio is 1:1.

Aim for a LTV:CAC ratio of 3:1 (i.e., each customer returns 3x more than what it cost to acquire them).

Average Revenue per User (ARPU)

Average revenue per user (ARPU) half the customer lifetime value equation. It tells you what each customer is worth on average at any given time.

To calculate ARPU, divide your total revenue by the number of active customers during that period.

Churn Rate

You can calculate your churn rate in two ways:

• Customer churn rate — how many customers stopped using your product within a specific time frame.
• Revenue churn rate — how much MRR or ARR you lost from that churn.

Customer churn is important from a customer success perspective — it speaks to your product’s quality and your team’s effectiveness at retaining customers.

Revenue churn is more helpful from a financial perspective. It tells you how much revenue you lost and need to replace through new sales and upsells to achieve growth. You might have a low customer churn rate, but if you’re losing your most valuable customer segments, your the financial impact of that could be huge.

Burn Rate

If you aren’t in the black yet, your burn rate is a metric that shows you how much money you’re losing each month.

It’s the net negative cash flow for that period, and it includes how much money you spend on operating expenses, any investments (e.g., R&D), and debt. It doesn’t include revenue or fundraising — only to show your company’s performance against its own expenses.

Cost of Goods Sold (COGS)

The cost of goods sold (COGS) is the amount you spend on producing and delivering your product or service. It includes direct costs such as hosting fees, equipment, and personnel directly involved in creating the product.

Knowing this number helps you accurately price your SaaS product, as well as understand where there may be room to optimize expenses.

Gross Margin

The SaaS gross margin measures the revenue left over after covering your direct costs of producing and delivering your software (cost of goods sold). It represents the funds available to cover operational expenses and fuel growth.

Since reflects how effectively your company manages costs, your gross margin speaks to the efficiency and growth potential of your business model. Having a high gross margin percentage signifies your company generates greater profit per dollar of revenue, while a low percentage suggests that your costs are reducing your profits.

That said, it’s important to note that it doesn’t account for operating expenses. That’s why it’s crucial to also monitor your SaaS operating margin and SaaS net profit margin.

Unit Cost

Unit cost measures unit economics — the efficiency of selling a single unit of your product. It breaks down your financial performance on a per-customer basis.

It’s also known as the cost per unit (CPU) and is calculated by dividing your revenue per customer by your total costs associated with that customer.

For example, Uber’s unit economics would be the profit from each ride divided by the costs that went into providing that ride (e.g., driver pay).

Best Practices for Financial Modeling in SaaS

Now that you understand the various SaaS financial metrics and how to calculate them, let’s dive into some best practices for effectively using financial modeling in your business.

• Consider best, worst, and most likely scenarios. Models that consider more than just one outcome are the most useful because they enable your team to prepare for potential risks.
• Define your model’s purpose up front. Since there are several ways to create a financial model, figuring out the questions you want answered ensures you’ll choose the right model and data points.
• Split up your financial model. Segment it based on financial drivers (inputs), the projected financial performance of your business (your calculations), and the expected results (outputs) to see how changes in your inputs impact the end result.
• Validate and compare with real data. To refine your model’s accuracy over time, continually compare your projections to actual financial results.

Steps to Build a SaaS Financial Model

SaaS companies build basic financial models in Excel or Google Sheets. As they grow, they end up using sophisticated financial modeling tools to create more accurate and dynamic models.

Use the following steps to create a financial model:

1. Pull data from financial statements.

Your balance sheet, income statement, and cash flow statement are the foundations of your financial model. They provide a clear picture of how money flows in and out of your business.

If you’re using bookkeeping and billing/subscription management software, you should be able to pull this data automatically fairly easily (just download it from the software itself or connect it to your model).

2. Create a problem statement.

Before anything, you have to define what your model actually forecasts. There are plenty of things you’d want to forecast for your SaaS business, and you’ll want to include them all in the model (otherwise you’ll need to build new ones).

For example, you can create models for revenue, churn, website conversions, and just about anything else imaginable. Each of these can be part of a larger model. You’ll only have to look at a sub-model (e.g., revenue) any time you want to forecast it. That’s why layout is everything for an all-encompassing financial model.

3. Determine who will use your model.

If you’re building a complex financial model, it’s important to only relay the information the viewer is looking for. You can create a comprehensive model and include instructions for users in different functions within the company. Or, you can build multiple models, each with its own purpose.

4. Enter your global controls and assumptions.

Global controls are the key assumptions and variables your financial model will use. You can’t get everything exact, which is why you need to make some educated guesses.

These include:

• The model’s start date
• Weighted average cost of capital (WACC) — the average cost of your company’s debt and equity financing
• Beginning cash balance
• Revenue growth and headcount assumptions
• Wage assumptions

This lets you govern the limitations of your model and set the stage for more detailed, on-the-fly adjustments.

5. Determine your financial drivers.

You need to know the inputs that determine your financial performance. If you wanted to model revenue performance, a few of your drivers would be:

• Number of leads
• Conversion rate
• Revenue per customer
• Customer lifetime value
• Churn rate

6. Create a layout for your model.

Every financial model consists of three essential sections: input, output, and calculations. It’s crucial to carefully plan each section independently.

By brainstorming the hierarchy of your model, you’ll create a coherent, easily understandable, auditable, and comprehensive model.

7. Determine how you’ll display the results.

Your financial model will return multiple results based on your inputs. So, you need to decide how you’ll display these results so they’re easy to read and understand.

You’ll also have to decide whether to display them all at once or on separate pages. In general, it’s better to display them separately for readability and simplicity.

8. Build your model and add scenarios.

Once you’ve determined the layout of your model, it’s time to start building. The critical elements here are equations, assumptions, and drivers. These should be placed in cells on separate tabs.

Once you’re ready to go, populate your historical data in their respective fields and create forecasts based on different scenarios.

By setting up different scenarios (best, worst, most likely) or by adjusting the inputs yourself, you can see how different factors impact your financial performance, and make adjustments to ensure you are on track for success.

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