The most valuable analysis

If there’s 1 thing I remember from my undergraduate finance degree it’s this:

The amount of financial ratios I had to memorize was insane.

I left college with the impression that a business is managed via ratios.

And just a few years into my finance career, I resented those ratios.

Why?

I didn’t use any of those ratios when building reports, doing analysis, forecasting a P&L, or working with business partners.

It felt like I had wasted my time in school.

But after almost a decade in finance, I’ve rediscovered the 1 critical ratio finance can leverage to help build a more valuable business:

LTV:CAC (which is technically 2 different ratios smooshed into 1 ratio, but who’s counting)

It’s the golden ratio that every successful business has mastered.

And FP&A holds the key to the data which puts FP&A in a position of power.

We’re going to break this down and explain how you can leverage it to drive value.

Let’s jump in:

What is LTV:CAC?

LTV to CAC stands for “Lifetime value to customer acquisition cost”

Which means it’s simply a ratio of 2 KPIs (LTV and CAC). Before we talk about the relationship between them, let’s briefly cover each one individually.

What is LTV?

Lifetime value (LTV for short) is a densely packed metric that tells you how much value your business receives on average over the lifetime of each customer.

LTV = Customer Value * Average Customer Lifetime

The main nuance that you’ll find here is how to interpret the word value.

Many interpret it as meaning revenue. However, I believe that a better way to interpret it is to mean profit (or specifically gross profit).

Which now tells us that we are looking at the amount of gross profit we receive on average over the lifetime of our customers.

And when calculating the lifetime of the customer, we’re simply identifying how many recurring or re-occurring purchases our customers make on average.

Here’s 3 different examples of LTV to help you out:

1. 1 purchase at $1,000 gross profit = $1,000 LTV

2. 5 purchases at $200 gross profit = $1,000 LTV

3. 10 month contract at $100 gross profit per month = $1,000 LTV

In the end, this metric tells you how much money you make from a single customer.

What is CAC?

Separately, we need to talk about customer acquisition costs (or CAC for short).

This is simply the amount of money, on average, that it costs you to acquire each customer.

CAC = Marketing and Sales Expenses / Number of New Customers

You can do this math by simply looking at the amount of money spent on sales and marketing divided by the number of sales.

There are 2 ways you can look at this:

• How much will it cost you to acquire your next [x] customers?

• How much did it cost you to acquire your last [x] customers?

It’s a subtle nuance, but worth considering depending on your business complexity. Younger businesses or those considering new acquisition channels should use the first method (forward-looking) while more mature businesses can leverage historical data to use the second method (backwards-looking).

In the end, this metric tells you how much it costs to acquire a single customer.

How to interpret LTV:CAC

If you can’t already tell how magical this formula is, let me spell it out:

• LTV tells you how much money you make from a single customer ($1,000)

• CAC tells you how much it costs to acquire a single customer ($400)

• Therefore, LTV:CAC tells you how much money you will make for every dollar you spend to acquire your next customer ($1,000 in gross profit per $400 in acquisition costs)

LTV:CAC is technically a ratio so is best expressed and read like:

For every $1 we spend to acquire a customer, we make $2.50 in profit over the lifetime of that customer.

In plain English: Every $1 you put in the business money machine yields $2.50.

Obviously a larger ratio is better. While a ratio at or below $1 means you are not making profit with each sale.

If we stopped here and you built a nice dashboard to show this KPI monthly, you’d be in a great spot. But this only scratches the surface of how powerful LTV:CAC can be for a business…

Leveraging LTV:CAC for strategic decisions

LTV:CAC answers some of the most critical business questions that CEOs and business owners often ask:

• Which products should we invest in?

• Who are our most profitable customers?

• What is the next best decision for my money if I want to scale the company?

Here’s a simple, but powerful framework you can leverage to make these decisions:

By developing the grid above for your product suite you’ll quickly understand the most efficient use of your next dollar.

The grid clearly shows you which product and acquisition channel investment is expected to yield the most profit for its investment. Higher numbers are best.

This analysis also works to dispel any myths about what people think is the best investment.

Set up this framework, start collecting data, and leverage this analysis to help drive your business towards more profitability.

Bonus: What if you don’t have the data?

Most small businesses won’t have the level of data they need to do this work. Not because they aren’t prudent, but because you often need experience in market before you can confidently leverage an LTV:CAC analysis by product and channel.

But there is a lightweight framework you can use that gives you similar results:

This grid will help you work through what products you currently provide, which ones are driving the most value for your business, and which ones are most expensive/difficult to fulfill.

The goal of an analysis like this is to quickly identify where you may be putting in a lot of effort but not getting an outsized return (product A, for example) - it might make sense to cut that product and allocate those resources to a better performing product (product B).

Key takeaways

Know your numbers so you can scale with confidence.

Start by breaking down your LTV, CAC, then do the same by product+channel.

Double-down on what’s working. Cut the stuff that isn’t.

Say hi 👋 on LinkedIn