Business metrics are powerful tools; however, they need to be gathered and accurately calculated, correctly understood, and used in the right context. Relied on worldwide by subscription-based software as a service (SaaS) companies, annual recurring revenue (ARR) is one of the key metrics used to:
- Gain a better understanding of the financial health of the business
- Determine more precise growth tactics
- Plan for new features and functionality
- Develop actionable expansion strategies
Essentially, annual recurring revenue provides a high-level view of the health of your business and helps in determining the rate at which you need to grow to keep the business profitable. With that in mind, let’s dig into what annual recurring revenue is, why it’s important, calculating it (and common calculation and interpretation mistakes), and how to increase annual recurring revenue.
What is Annual Recurring Revenue?
ARR is the normalized annual revenue that a company expects to receive from its subscribers in return for products and services provided. In other words, it is the predictable and recurring revenue generated by customers within a one-year period. Annual recurring revenue is not only the annualized version of monthly recurring revenue (MRR), but it also represents how much recurring revenue the business can expect based on yearly subscriptions.
Why is Annual Recurring Revenue Important?
As one of the key indicators that provide metrics to the overall health and performance of the business, it provides insights gathered from the data that comprises annual recurring revenue such as ARR from new customers, from customers who renew their subscriptions, incremental increases from upgrades, add-ons, etc., losses from downgrades, cancellations (churn), etc.
The long-term snapshot provided by ARR enables SaaS businesses to:
Forecast revenue: As one of ARR’s primary and essential functions, ARR enables businesses to accurately predict future revenue. By using ARR as the baseline, you can take other factors into consideration such as your churn rate, customer acquisition goals, potential pricing changes, potential packaging changes, etc. to paint a reasonably accurate picture of what future revenue will look like.
Track revenue from customer segments: The individual components of ARR enables you to determine and track which customer segments provide the most to your revenue, and which ones provide the least.
Improve subscription business models: Calculating ARR helps reveal your business model’s strengths and weaknesses, giving you the opportunity to make informed decisions. For instance, ARR provides the ability to better understand areas of opportunity in your current business model and take appropriate actions such as whether you should prioritize upsells or cross-sells, focus on customer acquisitions, reduce customer acquisition costs, etc.
Determine growth potential: The predictability and stability of ARR makes it one of the most tangible metrics to determine a company’s future growth (or decline). By comparing year-over-year ARR, you’re able to establish how your growth compounds over time. For early-stage SaaS companies, it’s a key metric investors and other stakeholders use to gauge the business’s overall performance. It also helps them make an educated guess on the long-term viability of the business.
The Differences: ARR vs. MRR and ARR vs. Total Revenue
While annual recurring revenue and monthly recurring revenue are strikingly similar except for a few characteristics, ARR and total revenue contain significant differences.
ARR vs. MRR
As the term implies, ARR is the annualized version of MRR, However, there are subtle differences. ARR represents your subscription-based company’s recurring revenue on a macro scale and is a valuation metric. MRR represents the company’s recurring revenue on a micro scale, is an operating metric, and can vastly fluctuate due the varying number of days in a month.
ARR vs. Total Revenue
While ARR measures your subscription-based revenue only, total revenue considers all the cash coming into your SaaS company. For instance, one-time fees for implementation, consulting, and training, as well as offerings that aren’t part of the subscription business aren’t considered when calculating ARR.
How to Calculate ARR
When calculating ARR there are numerous factors to consider like your pricing strategy, business model complexity, as well as other considerations. However, the basic ARR calculation formula is quite simple.
ARR = (total revenue of annual subscriptions + total revenue generated from add-ons and upgrades) – total revenue lost from cancellations and downgrades. It’s important to remember that one-time options should not be included in the ARR calculation.
If your SaaS business calculates MRR, the ARR calculation is even simpler.
ARR = MRR * 12
Simple Calculations for a SaaS Company
Let’s look at a straightforward scenario of calculating ARR for a multi-year subscription contract. Consider a SaaS company with one customer who purchased a three-year subscription for a total amount of $15,000. To determine the ARR, you would simply divide the total amount of the contract by the length of the contract.
ARR = $15,000 / 3 = $5,000
While the above example provides the basics of ARR calculations, it becomes increasingly complex based on numerous factors, including:
- Customer acquisitions and renewals: Total accrued revenue of new subscriptions and subscription renewals.
- Upgrades: Typically resulting from upsell/cross-sell campaigns that increase the annual subscription price on a recurring basis.
- Add-ons: Purchases such as add-ons and features that increase the annual subscription price on a recurring basis.
- Downgrades: Downgrades resulting from subscribers that change their subscription plan to one at a lower recurring annual subscription price.
- Cancellations: Customers that cancel their subscriptions. This figure also contributes to your overall churn rate.
The above provides the basis for calculating ARR, however other factors can come into play such as varying contract lengths, diverse pricing schemes, product bundles, discounts, etc. What initially appeared straightforward can quickly become problematic, which often leads to calculation errors, as well as inaccurate interpretations.
Common ARR Calculation and Interpretation Mistakes
While types and severity of annual recurring revenue calculation and interpretation errors vary, here are the four most common.
1) Including one-time transactions
Imagine you collected a one-time payment of $250 for a service. While the additional $250 gives your cash flow a boost, it can’t be considered in your ARR since the single purchase and payment is not recurring.
2) Excluding discounts or promotions
Let’s assume that you offer a $500 discount on a certain product. Subscribers taking advantage of the discount need to be accounted for in your annual recurring revenue calculations. Say the typical annual cost of a product is $4,500. Subscribers making purchases during the promotional period pay $4,000 instead of $4,500.
3) Including delinquent payments
It happens…customers don’t always pay on time. While you may have high expectations of receiving the payment, late payments can’t be included in your annual recurring revenue. The best way to handle payment delinquencies is to create a separate category and deduct the corresponding values from your ARR accordingly.
4) Including trials
Providing a free trial doesn’t guarantee that the prospect converts to a subscriber and shouldn’t be included in ARR calculations. And for those that do become subscribers, the trial period can’t be included in your annual recurring revenue.
Additionally, ARR calculations are often factored into statements they shouldn’t be, leading to misinformation. Generally, recurring revenue should only be reflected in your income or P&L statements.
How to Increase ARR
For subscription-based companies, building and maintaining profitability relies on customer retention. Aside from acquiring more subscribers, here are a few strategies to take into consideration to boost your annual recurring revenue.
- Keep customer acquisition costs (CAC) to a minimum: By comparing your recurring revenue with CAC you’ll determine factors such as CAC marketing spend. This way you can either reduce CAC costs or find ways to use the money more effectively.
- Increase customer lifetime value (CLV): This comes down to customer retention, and the most reliable way to increase ARR is by reducing churn. Ways to accomplish this include personalizing the customer experience, creating an internal team focused on customer retention, and targeting potential customers that your products will help resolve their challenges.
- Offer upgrades and add-ons: Incentivize customers to subscribe to a higher pricing subscription tier that contains sought-after upgrades, features, add-ons, etc.
Aside from the above, there are some long-term initiatives like cross-selling and upselling and increasing your subscription price points. Increasing price points is especially important if research determines that your pricing is less than your competitors.
Streamline Your Annual Recurring Revenue Processes
Keeping your subscription business profitable requires an accurate view of its financial health. However, managing your recurring revenue business isn’t easy, especially as your business grows. With growth comes high volumes of financial data and recurring payment transactions that can become daunting and error-prone, especially if handled manually or with a legacy billing system.
To stay on top of your annual recurring revenue processes and gain an accurate view of your financial health, you need to streamline and automate the processes. BillingPlatform provides the automation needed to gain a complete view of your financial standing so that you can run your subscription-based business with greater efficiency and accuracy. Are you ready to maximize the success of your annual recurring revenue business? Let BillingPlatform answer the questions you’ve been asking.