Owning a business means understanding critical aspects of the finances and how to maximize every bit of capital to grow and sustain your company. This is even more critical with a SAAS, or subscription service business. With that in mind, let’s talk about annual recurring revenue, including what it is and why it is essential for your business.
What is Annual Recurring Revenue (ARR)?
To put it simply, annual recurring revenue (AAR) is revenue normalized on an annual basis, which your business expects to receive from its customers for providing products and services. It provides a metric of predictable and recurring revenue generated throughout the year, and it is primarily used by companies that operate subscription-based business models. This metric also quantifies a company’s growth by evaluating its subscription model and forecasting revenue.
Using the ARR metric is similar to monthly recurring revenue (MRR). The only difference between the two is the amount of time being used to normalize them. When you opt to use ARR, you get a long-term view of your company’s progress that can be used by investors to determine if they want to be a part of your company. For management, ARR can be utilized to assess long-term business strategies and the financial well-being of your company.
Why is Annual Recurring Revenue Important for My Business?
With ARR, you have a critical metric to demonstrate the stability of your company’s revenue and its overall health, particularly for subscription-based businesses. Here are a few of the reasons why it is so important for your company:
Quantifies your company’s growth – Because it is predictable and stable, the ARR can be a good metric for demonstrating your company’s growth. When you compare them for several years, you can see whether your business strategy is creating growth or if there is stagnation. Thus, you can make adjustments to your strategy and business plan accordingly.
Evaluate business model – The truth is that you need metrics to determine whether your business model is viable or not. Unlike total revenue, which considers all the different inflows of cash, ARR only evaluates your revenue from subscriptions, so it can give you a clear indication of whether your subscription model is successful or not.
Forecasting revenue – ARR can also assist you in revenue forecasting, providing a baseline that can be incorporated into complex calculations to project future revenues.
How to Calculate Annual Recurring Revenue
First, you need to be clear that this formula is straightforward and excludes one-time or variable fees. Annual recurring revenue can be calculated from your figures related to multi-year contracts. If you have a customer who signs up for a 5-year subscription at $20,000, then you simply divide the $20,000 by 5 to get your annual recurring revenue of $4,000. You could follow this equation for each customer and then add them all up to get your ARR. In real life, there are multiple ways to break this figure down. Common components include the following:
- New customers
- Renewals from current customers
- Upgrades from current customers
- Downgrades from current customers
- Loss from churned customers
You can then see which customer segments are contributing to your ARR, as well as where you might need to focus attention to increase your ARR overall.
Annual Recurring Revenue Formula
The basic ARR formula is the total revenue earned from subscriptions. You simply multiply your MRR by 12. The MRR should include what was earned from monthly subscriptions, any new customers, upgrades, add-ons, losses from downgrades, and the amount lost due to churn.
Annual Recurring Revenue Calculation Examples
As mentioned above, you can utilize ARR on various segments to dig down and determine if you are growing your customer base, if upgrades and add-ons are increasing, and if you are experiencing a greater amount of churn than you had in previous years.
Examples of Annual Recurring Revenue (ARR)?
One of the easiest examples of ARR is a streaming service. After all, most of us have several of those services, and we pay for them monthly. Netflix, for instance, offers a multi-tiered pricing strategy, and using the ARR formula, they can determine whether more tiers might be necessary or if a tier needs to be eliminated.
So if a customer purchases the basic plan, they pay $8.99 for 12 months. After three months, they decided to upgrade to a premium plan for $15.99 for the remaining 9 months. First, you calculate the total amount of the yearly subscription, which is $8.99 x 12 = $107.88. Then you calculate the premium pricing of the upgrade, which is $7 x 9 = $63. There was no loss due to cancellations or downgrading, so your ARR is $170.88.
Now if they had gone six months before upgrading to a premium tier, then the ARR would be $149.88, because the total gained through the premium upgrade would only be $42.
If 50 customers upgrade to premium after three months, then the ARR will be 50 x $170.88 = $8,544. But with 50 customers upgrading six months in, the ARR is $7,494. As you can see, knowing your ARR and how these changes can impact it gives you the ability to get an accurate representation of your recurring revenue health.
What to Include in ARR Calculation
What you want to include is subscription-based revenue, including add-ons, upgrades, and new customers, as well as any losses of subscriptions due to downgrades or customer churn, aka cancelations. There are multiple variations that are possible, so you need to comb the data to understand where your changes are happening most frequently and to understand where adjustments might be needed in your pricing tiers or offerings.
What Not to Include in ARR Calculation
However, you should not include any of the following information, as it is not related to recurring subscription revenue:
- Set-up fees
- Credit adjustments
- Non-recurring add-ons
- One-time charges
Common Pitfalls to Avoid in Interpreting ARR
Now that you understand what you can learn about your business from the ARR, it’s time to understand the common pitfalls that you need to avoid while interpreting your ARR calculations.
Mistaking ARR for Cash
ARR is not the same as cash. After all, you can determine the ARR, but unless a payment is upfront, that does not equal the amount of cash held by the business. Mistaking ARR for cash can create an image that your business has more cash than it really does.
Looking Backward, Not Forward
Calculating ARR for the last 12 months doesn’t help you to determine where your business is growing. Fundamentally, ARR is a forward-looking metric, taking into account the revenue you can expect in the future, not what you generated in the past.
Not Accounting for Discounts
Discounts mean customers are not paying full price for their subscriptions. If you don’t account for that, you could end up with an inflated ARR.
Not Including Late Payments
To keep late payments under check, put a dunning mechanism into place, but then don’t forget to add them into your ARR calculation when those payments are received.
How Do I Increase My ARR?
There are several ways to increase your ARR, but most of them will focus on building the foundation of your business through customer retention, upgrades, and continually aligning your products to provide value to both new and current customers. Let’s dive into what that can look like in three key areas.
Find Your Ideal Customers
By understanding the types of customers most likely to use your service, then increase your net customer acquisition to get more qualified customers. Optimizing your LTV/CAC ratio can help to keep customer acquisition costs low and your acquisition strategy efficient. You also need to take into account the discounts for new customers. If they are leaving right after the promotion price ends, then you should consider whether your product truly aligns with your target audience.
Invest in Customer Success
Retaining your customers means aligning your products and services with a value metric that is in tune with your target customers. This paves the way for retained customers, as well as expanding the length of a customer’s lifespan with your service.
Play the Long Game
The goal of playing the long game is to recognize that you need to keep your business efficient while maintaining overall retention of customers. Although cost-cutting is usually challenging, since most subscription services are already operating at a low cost right from the start, you can consider reducing your CAC to be more efficient, although this will not impact your ARR as much.
Finally, the long game is about making your subscription an indispensable part of your customers’ lives. With the right upgrades and increasing the alignment of your product to the value metrics, you can keep your customers and even get them to use more of your services throughout the year.
Frequently Asked Questions
What’s the Difference Between ARR and Monthly Recurring Revenue (MRR)?
The difference is determined by the length of time, since the ARR focuses on one year, versus the MRR, which is focused on one month.
What Are Some Key Benefits of Tracking ARR?
You can see where you might be losing customers, account for discounts, and thus improve your strategies for both customer retention and upgrades.
What is a Good Recurring Revenue Percentage?
Essentially, that is going to depend on your business, but with an MRR growth rate, you can see whether your business has reached a product-to-market fit. It also shows how fast you are growing your customer base by acquiring new customers, retaining existing ones, or upselling current subscribers.
Is ARR Affected by Churn?
High churn escalates costs and can negatively impact a brand’s reputation. Acquisition costs also get higher, which means your revenue remains flat. To determine if your churn is too high, compare it to your company’s historical performance to determine if churn is moving in a favorable direction.
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AccountsBalance is a monthly bookkeeping service specialized for agencies & SAAS companies.
We take monthly bookkeeping off your plate and deliver you your financial statements by the 15th or 20th of each month.
You’ll have your Profit and Loss Statement, Balance Sheet, and Cash Flow Statement ready for analysis each month so you and your business partners can make better business decisions.
Interested in learning more? Schedule a call with our CEO, Nathan Hirsch.
And here’s some free resources:
In Summary
For a subscription business model, ARR is a critical metric that can help you determine whether your business is growing successfully or not. Plus, it helps to demonstrate how financially healthy your business is for potential investors. With the right focus on ARR and interpreting them correctly, you can adapt your business strategy for long-term success.
