The Annual Recurring Revenuemetric shows you how your businessis doing over the course of a year. It measures businessgrowth, stability, and profitability by looking at changes in recurring sales, renewals, upgrades, downgrades, and churn.
Without an accurate annual recurring revenue formulaand calculation, it's easy to get the health and future of your business's finances and growth wrong, which could mislead your teams and potential investors.
Subscription fees are the main source of income for any subscription-based business, and it's important to measure these fees accurately if you want to know how well your business is doing financially and make good investment decisions.
Having a metric that shows how the company's income changes from year to year makes it possible to plan for the long term and make a realistic plan for the company's growth. ARRcomes into the picture at this point.
What is ARR? Annual recurring revenue explained
Annual Recurring Revenue, or ARR, is a performance metric for subscriptions that shows how much moneyis expected to be made each year over the life of a contract or subscription.
In other words, Annual Recurring Revenue is the amount of moneya company expects to make from its current subscriptions and contracts on an annual basis. This metric doesn't count service fees or other types of income that aren't contractually owed to the company.
So, ARR can be used to figure out how healthy a subscription-based business, like a Software as a Service company, is by figuring out how much money the company can count on over the course of a year.
Annual Recurring Revenue can also be used as a way to measure a relationship. Since subscription commitments can show how customers feel about your product, their willingness to agree to a long-term relationship may show how much they trust your brand or how happy they are with it.
On the other hand, a lot of customers who prefer non-contractual interactions may mean that they need a little extra "push" to pay for your service.
ARR is often used with the word "projected" to make revenue sound bigger than it really is. For example, a SaaS product that makes $10 in its first month and $50 in its second month is growing at an exponential rate of 500%. The expected ARR is $1 million.
Whether you want to improve your products or raise their prices, you need to know how your decisions will affect your business in the real world for it to grow. Let's find out how ARR can help.
Using ARR, you can compare the financial health of your business from one year to the next. ARR measures how well a business is doing in different areas, like new sales, renewal rate, and upgrades, and shows where revenue is growing and where it is falling.
With these ideas, you can move forward with planning products, planning operations, and allocating resources.
ARR tells you how much money your business will make in the end, so you can compare it to your acquisition goals and pricing strategies to figure out where your business will be in the future.
This gives you a way to plan ahead for your future cash flow and the growth of your business. Also, with the ARR forecast, any change in a bad way can be a red flag that tells you what to do.
Potential investors use ARR to figure out how good your product is because it shows how stable and profitable a subscription business is. With ARR, you can compare how well a business has done over time and compared to its competitors.
Without ARR, it's easy to get the real direction of a business wrong and give stakeholders and potential investors the wrong idea.
One of the most important metrics for subscription-based businesses is their annual recurring revenue (ARR). The metric has some important uses for a business:
ARR is a good way to measure a company's growth because it is stable and easy to predict. By comparing ARRs from different years, a business can see if its business decisions are making any progress.
ARR only looks at the money a company makes from subscriptions, while total revenue looks at all the money it makes. So, ARR helps a business figure out if its subscription model is working or not.
ARR is often used for revenue forecasting, just like MRR. The metric is often called a "baseline," and it's easy to use it in more complicated calculations to predict the company's future sales.
What you should include in ARR calculations
- Any recurring subscriptions
- Upgraded accounts
- Downgraded accounts
- Lost revenue from churned customers
What you shouldn’t include in ARR calculations
- Set-up fees
- Account adjustments
- One-off upgrades
- Any other non-recurring charges
The formula for ARR is:
- ARR= (Total revenue from new subscriptions in a given period) + (Recurring revenue from existing subscriptions at the beginning of the period)
- -(Churned revenue from existing subscriptions during the period)
- +(Upgrades or downgrades to existing subscriptions during the period)
You can use this formula to figure out ARR on a monthly, quarterly, or yearly basis. To figure out ARR on a monthly basis, you would just change "period" in the formula to "month."
To figure out ARR for a quarter, you would replace "period" with "quarter." To figure out ARR on an annual basis, you would change "period" to "year."
How do I calculate ARR?
Before you can figure out ARR, you need to know how touse a basic formula for annual recurring revenue. Again, here's how we figure out annual recurring revenue:
Total revenue of yearly subscriptions + total revenue gained from expansion + total revenue lost due to churn and contraction = ARR
In other words, ARR equals the value of the contracted recurring revenue components of your term subscription, normalized to a one-year period.
Even though there are no set rules for figuring out ARR, it is usually made up of only fixed subscription or recurring fees that have already been paid. But when you figure out your annual recurring revenue, you should never include one-time fees and you should usually leave out subscription fees and fees that change.
Example 1: Customer A signs up for a service that will cost him or her $36,000 over three years. The contract calls for professional services and training worth $10,000.
- ARR= $12,000
- Explanation: One-time fees excludes. $36,000 / 3 year = $12,000
Example 2: Customer B pays $150,000 for a one-year subscription that includes four different subscription parts. The customer also agrees to get training worth $25,000.
- ARR= $150,000
- Explanation: One-time fees excludes. $150,000 / 1 year = $150,000. Most of the time, ARR is reported as a whole for all sales items.
Example 3: Customer C agrees to pay $15,000 for a 15-month contract that doesn't include any professional services.
- ARR = $12,000
- Explanation: $15,000 times (12/15) equals $12,000.
Example 4: Customer D pays $100 per month for a monthly service and uses it for 24 months.
- ARR= $0
- Explanation: There is no ARR unless the customer is signed up for a term, which is usually a year or more.
Example 5: Customer E signs up for a plan that lasts a year and costs $100 per month.
- ARR= $1,200
- Explanation: It doesn't really matter how the customer is billed. What's important is how much the agreement is worth. In this case, the customer has a one-year contract worth a total of $1200.
Example 6: Customer F signs up for a service that starts on January 17, 2020, and ends on September 30, 2021, and pays a total of $25,000 for it.
- ARR= $14,647
- Explanation: The term lasts longer than a year and is not made up of an even number of months. You will have to count the days from the beginning to the end and make them equal to a year. Excel's formula is ($25000/(EndDate – Start Date))*365, or you can use SaaSOptics to get the value automatically.
6 ways to increase your monthly recurring revenue (MRR) | Definition and Calculation
Another thing to think about is making sure that your customers are happy. If you have a revolving door, where customers leave faster than you can add new ones, your ARR can drop by a lot. Let's look at a few ways to help reduce churn and increase ARR.
Each new business should have an ICP (ideal customer profile). This is the standard you should use when coming up with ways to sell to potential customers.
Understanding the pain points of your customers and making sure your product can solve those pain points will help your business grow in the long run.
You have to spend money to make money, as the saying goes.
If a new customer is left hanging after signing on the dotted line, you can bet they'll start looking for greener pastures before you know it. Having a customer success team is another way to keep your customers (and your ARR) safe.
Incentivesand other short-term wins can be great in the beginning, but you should be thinking about the long-term. When you sell add-ons and upsells, your MRR goes up, which means your ARR goes up as well.
Other long-term options include increasing the price of a subscription after a set amount of time or raising the price of your services overall (especially if you feel like you are underpricing your product or service).
ARR stands for Annual Recurring Revenue, which is a key metric used by SaaS or subscription businesses with term subscription agreements, which means that the length of the contract is set.
It is the value of your term subscriptions' contracted recurring revenue parts, normalized to a one-year period.
ARR is the annualized version of MRR, but it is not the same as total revenue. The total revenue of your business takes into account all of the money that comes in, while the ARR only looks at your subscription-based revenue.
The ARR formula takes into account all of your business's recurring income. To figure out ARR, just add the dollar amount of annual subscription revenue to the dollar amount of revenue gained from expansion, then subtract the dollar amount of revenue lost due to churn.
Annual recurring revenue is an important metric for any business with a subscription model.
With this information, you'll not only be able to check on the overall health of your business, but you'll also be able to see how any actions you take affect the overall growth momentum. Recurring revenue is a strong sign that you can continue to grow.
Keeping track of these changes also helps you figure out the best way for your business to move forward. The better products you can make and the better team you can build, the more recurring revenue you have.
Without Annual recurring revenue as a starting point, your company won't be able to tell if it is still doing well.