Digital business models often have very different dynamics from traditional brick-and-mortar businesses. As such, traditional corporate KPIs such as revenue growth, gross and net profit margins, and return on assets often fail to capture a true picture of the health of a digital business. Below FirstRate Data outlines some of the key metrics modern digital businesses use to measure and evaluate their financial performance.
The Limitations of Legacy Financial Metrics for Digital Businesses
Revenue Recognition Misalignment: A software business is usually required to heavily invest in product development will typically show poor profitability as this cost is required to be expensed every year (versus more traditional businesses such as manufacturing companies that can capitalize the expenditure)
Asset Value Deficit: A digital company’s most valuable assets, such as software code, are often intangible and do not appear on a balance sheet as an asset despite their value.
Innovation Penalty: Traditional ROI calculations applied to businesses usually favor short-term, incremental improvements. Whereas, digital companies are attempting to deliver transformative solutions that can take years to generate returns.
Blending New and Traditional KPIs
Many companies are now augmenting the traditional financial measures of performance with modern KPIs more suited to gauging the health of a digital business.
Customer-Centric Financial Metrics
Customer Lifetime Value vs Customer Acquisition Cost Ratio (LTV:CAC)
This metric has become the single most important metric for most digital companies. Most customers of online businesses have an ongoing relationship with the company which means the value of acquiring a customer cannot be valued in a single transaction. As such, the value of the customer over their lifetime relationship to the company needs to be evaluated.
This lifetime value needs to be valued against the cost of acquiring the customer. The customer acquisition cost is often quite complex to calculate as customers will be acquired from multiple channels such as advertising, sales outreach, indirect marketing, and word-of-mouth and it will often be difficult to assign a customer to a single source. Typically, a blended cost across all channels.
What constitutes a good LTV:CAC ratio varies by industry, but QuantQuote (a financial information provider) estimates the average CAC for top quartile public companies at 3.7:1.
Payback Period
This metric is closely related to the LTV:CAC ratio and measures the period over which the cost of acquisition is recouped by the gross profits generated from the customer. The potential issue with a very strong LTV:CAC is that it might take a long time to realize the value of the customer, during which time the company will be forced to finance the acquisition expense.
The payback period is the time the company takes to recover the initial customer acquisition cost.
Longer payback periods signal that the company will require more capital to grow. The payback period typically depends of the customer type and not the industry. Selling to businesses will usually entail much longer payback periods than retail customers. A good payback period for a B2B business will usually be 18-24 months, whereas most businesses selling to retail customers target a payback period of under 12 months.
Net Revenue Retention (NRR)
For subscription businesses, NRR measures the ratio of revenue retained from existing customers, including additional revenue from a customer, such as for upgrades. An NRR above 100% indicates the business is organically growing from its existing customer base and not without the requirement to add additional customers. Thus a ratio of over 100% signifies a company with a strong business model and product offering.
