What Is Annual Recurring Revenue (ARR)?
Annual Recurring Revenue, or ARR, is a crucial metric used by SaaS or subscription businesses that shows the money that comes in every year from customers who are on a subscription (or contract).
Companies that offer yearly subscriptions use this metric to determine how much annual revenue they can expect for the next twelve months, assuming no other business is added or churned.
Some companies use a Monthly Recurring Revenue (MRR) metric, which is the same concept as ARR but expressed monthly. In general, companies that have a larger proportion of annual or longer-term contracts will use the ARR metric, whereas companies that have monthly contracts may opt to use the MRR metric.
How to calculate ARR
The ARR formula considers all the recurring (ongoing) revenue within your business. To calculate ARR, simply add the dollar amount of yearly subscription revenue with the dollar amount gained from expansion revenue and then subtract the dollar amount lost from churn.
ARR = (Overall Subscription Cost Per Year + Recurring Expansion Revenue) – Revenue Lost From Churned Customers
Expansion revenue (from recurring fees related to upgrades, upsells, and add-ons) affects the yearly subscription price of customers, so it must be included. However, your ARR calculation should exclude one-time charges or fees related to its products or services, such as one-time upsell, set-up fees, discounts, and any other non-recurring charges.
Why Is Annual Recurring Revenue Important?
Annual Recurring Revenue gives you an overview of how your business is performing year on year and enables you to forecast your growth more accurately over time. Having a solid foundation in your recurring revenue metrics can help you with the following:
- Understand the current state of your business
- Revenue forecasting
- Building lifelong customer relationship
- Attracting investors
Understand the current state of your business
A year-over-year analysis using ARR gives you the big picture of your business’s financial health. ARR measures the performance of the business in different areas, such as new sales, renewal rate, and upgrades, highlighting where revenue is growing and declining. With these insights, you can move forward on product planning, operational planning, and resource allocation.
Planning the duration and cost of different subscriptions helps forecast revenue from potential clients. Tracking the value of renewals and the cost of lost customers (i.e. churn) helps businesses manage expenses more precisely, maintain cash resources, and chart the business’s growth trajectory in advance.
Building lifelong customer relationship
For SaaS or subscription businesses, it’s less about selling products and more about building long-term relationships and staying relevant to customers’ ongoing wants and needs. It’s only with retained subscribers that a company can achieve recurring revenue.
Understanding how ARR value changes over time can help a company design product experiences for high retention and lifetime relationships.
Since ARR reflects the profitability and predictability of a subscription business, many investors value ARR as a key metric when evaluating startups and their founders as potential investments. With annualized revenue, there is no risk for seasonality to a product or slow months where monthly or one-time revenue cannot be relied on. With ARR, investors can be ensured that there is clear profitability on an annual basis which provides more security for their investment.