What it means
In the old model, a company bought a software licence for a large one-off fee, installed it on its own computers and paid extra for upgrades. With SaaS, the customer pays a monthly or annual fee and always uses the latest version, which turns a big upfront purchase into a predictable running cost.
For the provider, the financial pattern is very different from a traditional product business. Revenue arrives gradually over the life of the subscription, while costs such as development, hosting and sales are spent up front, so a fast-growing SaaS company can show losses even when customers love the product.
That is why SaaS businesses are judged on a particular set of measures. Monthly recurring revenue (the predictable subscription income earned each month), churn (the share of customers or revenue lost in a period) and customer acquisition cost (what it costs to win each new customer) tell you more about health than a single year's profit.
Accounting for SaaS needs care. Cash is often collected in advance for an annual plan, but the revenue is recognised bit by bit as the service is delivered, with the unearned part sitting on the balance sheet as deferred revenue (money received for service not yet provided).
For buyers, SaaS shifts spending from capital expenditure to operating expenditure, which can improve cash flow but makes the bill permanent. Contract terms, price rises at renewal and data security should be reviewed before a team signs up.
Investors value SaaS companies highly because recurring revenue is more predictable than one-off sales. The catch is that growth must be paid for, so the best businesses show that each dollar spent on winning customers returns more than a dollar over time.
In practice
Real-world examples.
Example
A small accounting practice replaces its desktop bookkeeping package with an online platform costing $60 per user per month. With five staff, the cost is $300 a month, and the practice no longer needs to buy servers or pay for yearly upgrades. Updates arrive automatically, so staff always use the current version. The practice can also add or remove users as its headcount changes, which is hard to do with a fixed licence.
Example
A marketing agency signs up for a project management tool on an annual plan of $2,400 and pays the full amount in January. Its finance team records $2,400 as a prepayment and expenses $200 each month, so the profit and loss account shows a steady cost rather than a January spike. If the agency cancels in June, it will have no claim on the unused months unless the contract allows a refund.
Example
A venture investor reviews a start-up selling scheduling software to dental clinics. It has $900,000 of ARR growing 8% a month, but customers cancel at 4% a month. The investor asks how long customers stay, because high churn would make the growth much more expensive to sustain. A clinic that stays for five years is worth far more than one that leaves after one.
Formula
Calculation
Monthly recurring revenue (MRR) = number of paying customers x average monthly subscription fee
Annual recurring revenue (ARR) = MRR x 12
Monthly churn rate = customers lost in the month / customers at the start of the month
A SaaS company has 400 customers paying an average of $250 a month. MRR = 400 x 250 = $100,000, and ARR = 100,000 x 12 = $1,200,000. If 20 customers cancel in a month, churn = 20 / 400 = 5%, which means the company loses about $5,000 of MRR (20 x 250) each month and must add at least 20 new customers just to stay level. Knowing these three numbers lets a manager judge growth without waiting for the annual accounts.Case study
Seen in the real world.
Brightdesk Software is an illustrative, fictional company that sells online helpdesk software to small retailers. After two years it had 1,000 customers paying $100 a month, giving ARR of $1,200,000, yet it kept reporting a loss because it spent heavily on advertising and engineers.
The finance director calculated that winning each customer cost $900 in marketing and sales, while the average customer paid $100 a month and stayed for 24 months. That meant lifetime revenue of $2,400 per customer, comfortably above the $900 cost, so the loss was an investment in growth rather than a warning sign. She also noticed that the cost of winning customers was rising each quarter, which needed watching.
The illustrative company then focused on cutting churn from 4% to 2% a month by improving onboarding. This lengthened the average customer life, raised lifetime revenue per customer and gave the board confidence to keep spending on growth. The finance director now reports churn, ARR and payback time in every board pack.
Watch out
Common mistakes.
- Treating annual cash received in advance as revenue earned in the month it is collected, which overstates early profit and understates later months.
- Focusing on new customer growth while ignoring churn, so the business keeps refilling a leaking bucket.
- Assuming SaaS is cheaper than owned software in every case, when a subscription paid over many years can cost more than a one-off licence, especially once annual price rises are included.
Questions
People also ask.
What is the difference between SaaS and a software licence?
A licence is bought once and installed on the customer's own systems, while SaaS is rented on a recurring basis and run on the provider's systems.
Is SaaS revenue recorded when the customer pays?
Not necessarily, because revenue is usually recognised gradually over the subscription period as the service is delivered, with cash received early held as deferred revenue.
What is a good churn rate?
It varies by market and customer size, but lower is always better, and businesses selling to large companies usually see lower churn than those selling to consumers or very small firms.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%