What is Annual Recurring Revenue (ARR)?

Annual Recurring Revenue (ARR) is a metric that calculates the recurring revenue generated by a company every year. ARR is crucial in analyzing the performance of the subscription business. It also helps predict the future income that the company could generate.

Subscription-based companies hugely rely on a month-to-month or contractual revenue generation to run the company. However, the SaaS industry is gaining popularity rapidly and is one of the most reliable sources of recurring revenue. A host of companies launch every year with a new SaaS product every day, and the competition in the industry is skyrocketing.

Tracking the correct metrics provides companies with the insights they need to implement new strategies to sell their service efficiently to customers. One of the essential metrics that subscription-based businesses track is Annual Recurring Revenue, or ARR.

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Why is ARR important for subscription businesses?

Annual Recurring Revenue is one of the key business metrics to track in a subscription Dashboard like Stripe, Chargebee, etc.

In order to assess a company’s financial health over a long time, it is crucial to track the current financial performance of the company. ARR gives the company an idea of whether its service is achieving company goals and how it can change its strategy to boost performance. Here are a few ways in which ARR helps the business flourish.

Revenue forecast. ARR analyzes the different durations and prices of subscription plans of a service and analyzes what plans work best for the business. Based on the recurring revenue generated and the churn rate, companies manage their expenses more tactfully and identify areas that need more focus.

Attract Investors. Multi-year contractual revenue has a more predictable revenue flow. Investors are attracted to companies with a stable ARR since it depicts that the company has a great product and a healthy business strategy.

Evaluating business model. Every SaaS company undergoes a lot of trial and error to figure out what does and doesn’t work for the business. Tracking ARR helps evaluate the strengths and weaknesses of a company. This enables companies to make necessary adjustments to their business model, thus boosting their sales.

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How do you calculate ARR?

While ARR is the recurring revenue of a company every year, MRR or Monthly Recurring Revenue is the recurring revenue generated by the company on a monthly basis. ARR can be calculated by multiplying MRR by 12.

The formula to calculate ARR is:

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ARR formula — Annual Recurring Revenue Formula

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Let us look at an example. If 4 customers have subscribed to a monthly plan worth $2000 and 6 customers have a $3000 monthly subscription, the average revenue per customer would be $2600. Therefore, calculating ARR would be as follows:

ARR = MRR [$2600 * 10] *12

ARR = 3,12,000

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What to include in ARR Calculation?

Recurring payments. This includes the revenue generated from subscriptions from customers on a recurring or contractual basis. Payments such as recurring subscription charges or recurring fees would fall under the recurring payments category and should be included while calculating ARR.

Upgrade revenue. When an existing customer moves from their current subscription plan to a higher one, it is called upgrade revenue. Upgrade revenue is usually generated through upsells. This increases that particular customer’s recurring revenue. Therefore, upgrade revenue should be included while calculating ARR.

Downgrade revenue. When a customer moves from an existing subscription plan to a lower one, it is called downgrade revenue. This indicates MRR churn and helps track the amount of ARR lost from that customer.

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What to exclude in ARR calculation?

One-time fees. Since ARR calculates the total recurring revenue generated in a year, one-time payments such as late fees should be excluded while calculating ARR.

Set-up fees. Set-up fees are a single additional payment the customer makes to set up the service. Since it is not a recurring payment made by the customer, it should be excluded while calculating ARR.

Non-recurring add-ons. Businesses offer several add-ons that are both recurring and non-recurring in nature. If the customer subscribes to recurring add-ons, those may be included while calculating ARR. However, if it is a one-time add-on payment that the customer makes, then the amount would not be included in the ARR calculation.

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Difference between ARR & MRR

Monthly Recurring Revenue is the total recurring revenue generated from subscriptions every month. ARR, on the other hand, is the total recurring revenue generated from annual subscriptions.

While both MRR and ARR are metrics that predict the revenue generation of a company, MRR has an in-depth approach, whereas ARR provides a complete view of the business.

ARR is a long-term metric that calculates the success of the company in the long run. MRR provides insights that help enhance operational efficiency in the immediate future.

Another significant difference between ARR and MRR is that ARR is usually calculated for multi-year subscription deals. MRR is calculated by companies that have a monthly subscription plan.

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Common Mistakes to avoid while calculating ARR

Mistaking ARR for Cash. A company’s cash flow depicts the total revenue that comes into a company. Whereas ARR is a metric that measures the financial performance of a subscription-based business. Therefore, non-recurring or bulk payments should not be included while calculating ARR. It should instead be included in cash flow. Bulk payments usually made by businesses with multi-year contracts should be divided by the total number of years before including it in ARR calculations.

Looking Backward instead of Forward. ARR is a metric that helps predict the revenue generation of a SaaS company in the future. Therefore, ARR is not supposed to be calculated by adding the total revenue generated in the past 12 months. As a forward-facing metric, it calculates the estimated revenue that the business can develop in the future, not the total revenue generated in the past.

Not Accounting for Discounts. Occasionally companies offer their services to customers at a discounted subscription price. However, a few companies mistakenly include the total subscription amount instead of the discounted amount. This messes up the calculations, which results in a false ARR projection.

Excluding Late Payments. There are several instances in SaaS businesses where delinquencies occur. These are usually caused by timed-out credit cards. However, when the late payments are finally made, it is important to add them while calculating ARR.

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