What is Annual Recurring Revenue?
Annual Recurring Revenue (ARR) is the revenue that a business expects to generate every year on a recurring basis. It measures the performance of a business on a year-over-year basis. It includes coupons, discounts and recurring add-ons. It doesn’t include one-time charges like setup fees, non-recurring add-ons and taxes. Recurring revenue is typically calculated monthly or annually. It is thus a forecast of the revenue of a subscription business for the coming year.
ARR calculates a businesses’ total yearly recurring revenue from all customers whereas MRR accounts for the monthly recurring revenue from all customers.
Relevance of Annual Recurring Revenue in Subscription Business
ARR is an important SaaS metric because it gives businesses the ability to understand how much expansion revenue is coming from new sales and upgrades, as well as lost revenue coming due to customer churning and downgrades. It is a good indicator of a business’ health and helps forecast future revenue. SaaS companies with a healthy ARR stand a better chance at attracting more customers and keeping them satisfied.
Investors also rely on this metric for financial forecasting, budgeting and growth planning. They use the metric to assess the long-term relevance of the business, its growth potential and to get an estimate of its future cash flow. SaaS businesses with strong ARR thrive because they can grow systematically and sell predictably, which increases their chances of success.
How to calculate ARR?
This metric can be calculated in different ways and the method used depends on the available data. Let’s explore few of the different approaches employed to calculate it.
ARR = MRR x 12
This formula is used to calculate annual recurring revenue when a constant value for Monthly Recurring Revenue is available throughout the year.
ARR = (Sum of subscription revenue for the year + recurring revenue from add-ons and upgrades) – revenue lost from cancellations and downgrades that year.
This is applicable to businesses where the customer counts or upgrades are seen to fluctuate.
ARR = (Contract Value) X (12 / Duration of Contract in Months)
This formula is applicable when the customers are billed on a monthly-basis.
ARR = Contract Value / Duration of the Contract (Years)
This is applicable when customers are billed on a yearly basis
It is important to note that to generate an accurate ARR value, all the charges included in the contract value should be recurring. These calculations are applicable in accessing the health of a subscription business.
What are the Do’s and Don’ts in ARR Calculation?
Do’s
Standardize ARR Calculation – Standardizing the calculation ensures that there is consistency in the way it is calculated across the organization. This eliminates all confusions that may arise when different methods are used to calculate this metric. ARR calculated this way allows all stakeholders involved in the subscription business to clearly and easily understand the company’s revenue trajectory.
Don't Consider Non-Recurring Revenue – Non-recurring revenue refers to one-time charges like setup fees, consulting fees, training fees, implementation fees and a lot more. These should not be considered while calculating ARR due to their non-recurring nature. This way, investors get an accurate and realistic view of the company’s financial health.
Include revenue changes from upgrades and downgrades – Considering revenue changes through upgrades and downgrades is crucial for accurately calculating the ARR of a subscription business. Upgrades adds to the revenue while downgrades reduce it. Incorporating these for calculation helps in providing an accurate picture of the company’s true revenue growth or shrinkage.
Consider customer churn – Customer churn is key in calculating this metric since it directly affects recurring revenue. ARR reflects the predictable, recurring revenue generated through subscriptions on an annual basis. So, a high churn decreases ARR and vice versa. Lost customers mean lost subscription which automatically equates to low annual recurring revenue.
Don’ts
Exclude variable usage fees – This metric signifies recurring or stable revenue and hence should not include variable usage fees for its calculation. Any fees that fluctuate based on usage is unpredictable and hence should not be considered while calculating ARR. Including these variable charges can skew ARR results which can further result in unreliable ARR values.
Don’t confuse metrics – Subscription business has many metrics, but ARR should focus solely on recurring revenue that is generated from active, annual subscriptions or contracts. This way, this metric signifies a clear measure of predictable and stable revenue.
Don’t ignore contract start and end dates – This is a metric that is calculated based on an annualized time frame and hence it is important to record the exact start and end date of each subscription or contract. This ensures that only active subscriptions are used for calculation avoiding overestimation from expired or inactive contracts. This approach provides accurate calculation that supports financial planning needs.
ARR does not give a true picture of cash flow analysis – ARR reflects only the predictable, recurring revenue and do not capture the actual cash inflows. The actual cash inflows are the sum total of all revenues from recurring to one-time charges. A subscription business with high ARR can face cashflow issues if the customers delay making payments or if the onboarding and support costs are high. Hence, the annual recurring revenue alone doesn’t provide a complete picture of the financial health of a business.
Don’t forget currency adjustments - If you are a subscription business that is operating on a global scale, considering currency adjustments is crucial. If ignored, ARR calculation can seem flawed and inaccurate and will not reflect the actual revenue.
How to Grow your ARR?
• Work on customer retention – Working on customer retention or maximizing their lifetime value plays an important role in significantly boosting the annual recurring revenue. Retaining customers means sustained revenue from existing clients, which further reduces the negative impact of customer churn. These loyal customers are likely to up-sell and cross-sell which boosts the value of this metric without the added costs of acquiring new clients.
• Focus on upselling and cross-selling – Upselling happens when a customer upgrades to a higher plan and cross-selling happens when a customer purchases additional features that enhances the current subscription. Both these actions can boost this metric by increasing the amount of time that customers spend over time.
• Keep optimizing pricing – Prices of products and services should be optimized such that customers are encouraged to stay in the system and upgrade to higher-priced plans and purchase add-ons. This increases the revenue per user which further boosts ARR. Optimizing pricing and making it feel valuable for the services delivered can improve customer retention, which further reduces churn and creates a stable ARR.
• Leverage data and analytics for decision-making – Data and analytics play a significant role in understanding customer behaviour and preferences. This helps in making decisions for them by suggesting opportunities to upsell or cross-sell which can further help in customer retention. These data can assist in setting pricing strategies, personalizing offerings, developing targeted marketing campaigns which can again attract and retain customers. This can also, reduce churn and increase the lifetime value of each customer. These analytics can also help to optimize customer acquisition costs and ensure efficient allocation of resources which further contributes to sustainable growth in ARR.
