Capital Efficiency Ratio

What is a capital efficiency ratio, and does it matter for VC-backed startups?

For startups, particularly in the SaaS sector, the efficient use of capital is not just an operational need, but a strategic imperative. It’s how VCs judge a company’s success, and how well capital is used determines how much funding a startup needs to raise. The Capital Efficiency Ratio is one metric that can help try to explain how a startup is using cash, although it’s a bit dated of a metric (in my opinion) - I’d suggest a burn multiple instead.

That being said, let’s dive in.


The Traditional Measure: Capital Efficiency in Public Companies 

Historically, capital efficiency has been closely tied to the concept of Return on Capital Employed (ROCE) within corporate finance, specifically in the context of public companies.

Formula: ROCE = EBIT / Capital Employed 

ROCE measures the company’s ability to generate returns from its capital. It’s calculated by dividing the company’s Earnings Before Interest and Taxes (EBIT) by the capital employed (total assets minus current liabilities). 

For instance, if a company has an EBIT of $200,000 and capital employed of $1,000,000, its ROCE is 0.2 or 20%. This means it’s returning 20% of its value as profit to stakeholders within a specific period.  Notice that this measure is focused on how much profits are being driven by the capital - not just the revenue. And note that it includes all sources of funding, not just equity. 

Startup investors have attempted to recreate this metric, with mixed success in my opinion.

Capital Efficiency Ratio for Startups

When we move to the startup and SaaS realm, the definition of Capital Efficiency Ratio adjusts to reflect how efficiently a startup is deploying its cash to grow revenue. 

Formula: (Total Equity Raised + Total Debt Raised - Cash Remaining) ÷ ARR

This formula uses the sum of total equity and total debt, subtracts cash, and divides the result by the Annual Recurring Revenue (ARR). It’s important to note that the equity number is based on the total equity raised, not the balance sheet number (which goes down as the company created negative retained earnings). Basically, it’s showing how much capital a company has burned to generate its ARR. 

Suppose a startup has raised total equity of $3,000,000, total debt of $1,000,000, has cash of $500,000, and an ARR of $2,000,000. The Capital Efficiency Ratio would be ($3,000,000 + $1,000,000 - $500,000) ÷ $2,000,000 = 2. This means the company uses twice the amount of capital to generate a unit of ARR.

Unraveling the Capital Efficiency Ratio: A Caveat 

Although some find it insightful, I think the Capital Efficiency Ratio has some serious issues.Its primary shortcoming is its focus on revenue rather than gross profit. The ratio doesn’t offer a crystal-clear snapshot of cost-efficiency and unit profitability. While you could argue that the revenue profitability is sort of taken into account in how much cash has been burned, I don’t think it’s as solid of a metric as it is for a traditional business, where EBIT is judged, not ARR.

Enter the Burn Multiple: A More Holistic Measure

Formula: Burn Multiple = Net Burn / Net New ARR 

Given the limitations of the Capital Efficiency Ratio, the Burn Multiple is often lauded as a more comprehensive metric. It measures the ratio of net burn (cash inflows minus cash outflows) to net new ARR (change in ARR over a given period). 

Suppose a startup has a net burn of $300,000 and net new ARR of $150,000. Its Burn Multiple is $300,000 / $150,000 = 2. This implies the startup is burning twice the amount of cash for each new unit of ARR it adds.

We discuss this metric in-depth in an article dedicated to the burn multiple.

In sum, while the Capital Efficiency Ratio provides an ok snapshot of a startup’s revenue generation efficiency, it’s not the whole picture. Complementing it with other metrics like the Burn Multiple offers a fuller understanding of a startup’s financial health.

For non-startups, historically, the capital efficiency and return on capital efficiency (ROCE) have been interchangeable terms — particularly in the context of corporate finance at public companies.

Traditional businesses - and public company - capital efficiency calculations

The traditional capital efficiency calculation per ROCE is your company’s earnings before interest and taxes (EBIT) divided by your capital employed (your total assets minus current liabilities).

Your ROCE gauges the company’s performance, as it looks at overall net profit. A high ROCE score shows a higher percentage of the company’s value returned as profit to stakeholders within a specific period of time. To get the most out of ROCE, it’s best to compare competitors’ ROCE ratios to gain a sense of the marketplace. You also want to expand your ROCE findings with other return ratios, like return on invested capital, return on assets, and return on equity, to gain a complete picture of your revenue.

ROCE is more appropriate for gauging the profitability of public companies, as it’s not an accurate representation for companies with large, unused cash reserves (such as Seed Stage,  Series A, and Series B companies).

What is the Capital Efficiency Ratio?

Total Equity plus Total Debt minus Cash ÷ ARR

We use Total Equity plus Total Debt minus Cash as a good proxy for the amount of capital a company has used so far in its journey. The Capital Efficiency Ratio is the ratio of how much a company has spent growing revenue and how much they’re getting in return. It looks at how efficiently a startup is using its cash to operate and scale.

A lower Capital Efficiency Ratio is better. In a recent Key Banc Capital Markets study of SaaS companies the median is 1.5x, with a range of 1.2 – 3.4x for $5M ARR companies. Founders should take a higher ratio as a warning sign that capital is being strained, but bear in mind that this metric will not be meaningful prior to early ARR traction.

Cash Conversion Score - one measure of capital efficiency

Cash conversion score = current ARR / (total capital raised to date - cash on balance sheet)

To calculate your cash conversion score, take your current ARR and divide it by the difference between total capital raised to date and your net of current cash (your equity and debt minus cash from your balance sheet).

Cash conversion score formula

Bessemer Venture Partners set the cash conversion score formula and benchmarks to evaluate prospective companies’ future success. The cash conversion score calculation results on a scale between 0.25x and 1.0x+, where a 1.0x score means that a company makes $1 of top-line recurring revenue per $1 invested in the business. Bessemer divides scores into a “Good, Better, Best” framework:

Good. A cash conversion score of 0.25x to 0.5x indicates an internal rate of return of about 40%.

✅✅ Better. A cash conversion score of 0.5x to 1.0x correlates to an internal rate of return of about 80%.

✅✅✅ Best. A cash conversion score of 1.0x or better is considered best-in-class, translating to a 120% internal rate of return.

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