Before you make business decisions or claims about profitability, you should have hard data to back it up. Small business financial ratios quantify your accounting data so you can improve operations, give lenders or investors insight into your business’s profitability, and measure growth. One popular metric businesses put stock into is the LTV:CAC ratio.
Your LTV:CAC ratio gives you insight into your marketing expenditure. To make wise financial decisions, you need to know whether your spending pays off or not.
What is the LTV:CAC ratio?
The LTV:CAC ratio represents the relationship between your business’s customer lifetime value (LTV, CLV) and customer acquisition cost (CAC). A customer’s lifetime value estimates how much revenue a customer will spend in your business over time. Customer acquisition cost is how much money you spend marketing to new customers. The LTV:CAC ratio reveals your marketing return on investment (ROI).
Every business owner wants to see high returns on investments. Use the LTV:CAC metric to compare how much money you spend acquiring new customers to the estimated amount customers will spend at your business.
Calculating your LTV:CAC ratio may help you create budgets, know where to cut marketing costs, and improve the way you sell to customers.
You might be wondering what an ideal LTV:CAC ratio looks like. How do you know if you need to improve your ratio? When is it just right?
Although many factors can influence LTV:CAC ratios—including industry and time in business—most experts agree that a ratio of 3:1 or higher is ideal. A 3:1 ratio means that your customers spend three times the amount you spend acquiring them at your business.
For the LTV:CAC ratio, you must avoid getting a result of 1:1. A 1:1 ratio means you are putting in just as much money as you are getting out, which keeps your small business’s growth stagnant.
Calculating your LTV:CAC
To calculate your customer lifetime value to customer acquisition cost ratio, you must first gather some information. You need to know both your customer acquisition cost and customer lifetime value metrics.
Calculate your customer acquisition cost by dividing your total marketing and sales expenses by the number of new customers during a designated period, such as a month, quarter, or year.
Finding your small business’s customer lifetime value calculation is more extensive than calculating your CAC. You need to know your business’s average purchase value, average purchase frequency, and average customer lifespan (i.e., how long a customer sticks with your business). Use the visual below to help you calculate purchase value, frequency, and lifespan. Then, multiply your average customer lifespan by the difference between purchase value and purchase frequency.
Once you know your customer acquisition cost and customer lifetime value numbers, you can plug them into the LTV:CAC ratio formula.
LTV:CAC ratio formula
Use the following formula to find your LTV:CAC ratio:
LTV:CAC = Customer Lifetime Value / Customer Acquisition Cost
Your numbers for LTV and CAC are in dollars. Your ratio result shows how much money customers spend compared to how much money you spend acquiring them.
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Customer lifetime value to acquisition cost ratio example
Let’s say you want to find your LTV:CAC ratio for the year. You spent $15,000 and acquired 150 new customers. Your business earned total annual revenues of $125,000. You had 2,000 purchases coming from 1,500 customers (unique customers). Looking at historical data, you determine your average customer lifespan is five years.
If you want to find your LTV:CAC ratio, you need to calculate customer acquisition cost and lifetime value.
First, calculate customer acquisition cost by dividing your expenditure by new customers:
CAC = $15,000 / 150
CAC = $100
Next, calculate your customer lifetime value. You need to find your average purchase value and average purchase frequency. Reference the chart above for formulas.
Average Purchase Value = $125,000 / 2,000
Average Purchase Value = $62.50
Average Purchase Frequency = 2,000 / 1,500
Average Purchase Frequency = 1.33
To find your customer lifetime value, you must subtract purchase frequency from purchase value. Then, multiply that number by average customer lifespan.
LTV = ($62.50 – 1.33) X 5
LTV = $305.85
Now that you know your customer lifetime value and customer acquisition cost, you can plug them into the ratio formula:
LTV:CAC = $305.85 / $100
Your LTV:CAC ratio is approximately 3:1, showing that you earn three times the amount you spend on customer acquisition.
Things to keep in mind when calculating your LTV:CAC ratio
Before putting too much stock into the results of your ratio, understand that it is subject to change. Both customer lifetime value and customer acquisition cost metrics can be misleading.
Your customer lifetime value metric is merely an estimate of the future. Your LTV may be higher or lower than you anticipate, depending on the economy, customer satisfaction, and competition.
Businesses that rely on customer acquisition cost data may not be able to accurately break down marketing and sales costs. You likely market and sell to current and existing customers, making it difficult to allocate your spending on acquiring new customers.
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This article has been updated from its original publication date of January 17, 2019.
This is not intended as legal advice; for more information, please click here.