What is Annual Recurring Revenue (ARR)? | How to Calculate It?
The quest to achieve a 'meaningful Annual Recurring Revenue (ARR)' is a topic that often comes up in the SaaS world. Many founders find themselves in a race to achieve perfect ARR targets that investors deem as meaningful.
Some sources use ARR to benchmark SaaS companies to evaluate their 'growth rates.' Here's an example of Bessemer Ventures’ 'Emerging Cloud Index'.
That’s why it's no surprise that 89% of SaaS businesses use ARR growth as their core financial metric.
But ARR isn’t a simple calculation–it’s a guiding light for your business’s growth. Yet we have seen a lot of SaaS companies calculating ARR incorrectly, which can mislead your businesses’ true health.
So, let's take a deeper look into what Annual Recurring Revenue (ARR) is, why it's important, how to calculate it, and most importantly, how to optimize it to get a clear picture of your business’s growth.
What is Annual Recurring Revenue (ARR)?
Annual Recurring Revenue or ARR is predictable recurring revenue generated by businesses over the period of 12 months. ARR includes all types of recurring revenue, such as membership fees, subscriptions, and licence fees.
For instance:
- Recurring payments from services rendered monthly.
- Recurring payments for products delivered on a quarterly or annual basis.
- Revenue from subscriptions and memberships to online content and community.
Annual Recurring Revenue is a helpful metric for businesses that make the vast majority of their revenue through annual or multi-year contracts. There is a high level of certainty that this money will be collected.
ARR will automatically increase when subscriptions with existing clients are uplifted or when the company sells new subscriptions. Similarly, ARR will decrease when subscriptions are churned.
Hence, as long as the total revenue collected from new contracts and existing subscriptions surpasses the value from churned contracts, revenue generated year after year will increase.
Key takeaways
- Annual Recurring Revenue is the total revenue generated from contracts, subscriptions, and other billing cycles over the next 12 months.
- ARR helps CFOs, investors, and marketing teams to quantify growth, forecast revenue, and determine customer retention, acquisition, and cancellation trends.
- SaaS businesses can optimize their ARR by increasing new user count, expanding average revenue per account, and reducing churn.
How do you calculate annual recurring revenue (ARR)?
Annual Recurring Revenue is calculated by adding all recurring revenue and subscriptions and subtracting lost revenue.
The ARR formula is:
(Total revenue from new subscriptions during the period) + (Recurring Revenue from existing subscriptions at the start of the period)
- (Churned revenue from existing client contracts during the period)
+ (Upgrades or downgrades from existing subscriptions during the period)
One of the most important things that should not be included while calculating ARR is non-recurring revenue.
These include one-time payments such as installation charges or sign-up fees, discounts, or other monetary benefits that are not going to be repeated next year. Another is recurring services like consulting services that are not part of ongoing contracts.
While these one-off payments may contribute a significant portion of your revenue but since they are not part of the recurring revenue stream, they will not be included while calculating ARR. However, different companies may have different approaches to calculating non-recurring revenue in ARR calculation.
What is the difference between ARR and MRR?
MRR, or Monthly Recurring Revenue, is similar to ARR, but it's calculated on a monthly basis. Both of these metrics serve the same purpose of calculating how much a contract is worth.
However, there are a few differences between ARR and MRR:
Examples of Annual Recurring Revenue (ARR)
Let’s put the ARR formula into perspective:
Example 1: Simple ARR calculation
For instance, a SaaS company offers two paid subscriptions of $10 (Basic plan) and $15/user/month (Pro plan). Currently, they have 100 Basic subscribers and 50 Pro subscribers.
Calculate ARR:
Total amount from subscriptions=
Basic plan= 100 subscribers x $10/month= $1000
Pro plan= 50 subscribers x $15/month= $750
ARR calculation= ($1000+$750) x 12= $21,000
The annual recurring revenue for SaaS will be $21,000 this year.
Example 2: Complex ARR calculation with cancellations and downgrades
Now, for instance, the same SaaS company experienced some cancellations and downgrades in the year. During the year, the company lost 10 Basic plan subscribers and gained 20 Pro subscribers. In addition, 15 Pro subscribers were downgraded to the Basic plan.
Additional data:
- Loss of revenue from Basic subscribers= 10 subscribers x $10= $100
- Gained revenue by additional Pro subscribers= 20 subscribers x $15= $300
- Revenue shifts from downgrades (Losing 15 Pro subscribers at $15/month to the Basic plan and gaining 15 subscribers in Basic plan at $10/month)
= Loss: 15 subscribers x $15/month= $225
= Gain: 15 subscribers x $10/month= $150
= Net loss from downgrades= $75
ARR calculation:
- Adjusted total revenue from subscribers after downgrades and cancellations:
New Basic plan revenue = 105 subscribers x $10= $1050/month
New Pro plan revenue= 65 subscribers x $15= $975/month
- Total from adjusted subscriptions= ($1050+$975)= $2,025/ month
- Net ARR considering loss:
ARR before loss= $2025+ $75 x 12= $25,200
Annual loss from cancelation= $100 x 12= $1200
Annual profit from additional subscriptions= $300 x 12= $3600
FInal ARR= $25,200-$1200+$3600= $27,600
The adjusted ARR of $27,600 showcases the actual expected outcome, accounting for an increase in new subscribers and lost revenue due to downgrades and cancellations.
Types of Annual Recurring Revenue (ARR)
ARR can be broken down into several types, each providing insight into different aspects of revenue growth and stability. Here are the primary kinds of ARR:
- New ARR: This ARR represents revenue generated from new subscribers or upgrades in pricing or plans. It is an early indicator of whether your current growth strategies are working or not. The New ARR metric also enables companies to compare themselves with their industry peers and measure how they are performing relative to their competitors in the same space.
New ARR= New ARR (New Customers) + Expansion ARR (Existing Customers) + Churned ARR (Lost Customers)
- Renewal ARR: For SaaS businesses, Renewal ARR measures revenue generated from renewed subscriptions. It provides valuable insights into the health of your SaaS businesses by measuring how many customers decided to stay after one year and beyond. Renewal ARR indicates customer loyalty and satisfaction with your product.
ARR up for Renewal = ARR from expiring customer contracts
- Expansion ARR: Expansion ARR refers to the cumulative revenue generated from all new subscriptions, upgrades, bookings, and cross-sells from an existing customer. Unlike 'New ARR,' this expansion metric determines the business's ability to grow existing customer accounts.
Expansion ARR formula= New ARR (Existing Customers) + Upgrades, Bookings, Cross-sells from existing customers.
- Churned ARR: Churned ARR measures the amount of recurring revenue lost from customers who canceled or downgraded. This metric highlights a company's ability/ inability to retain customers. By understanding the amount of churned revenue, businesses can discover potential issues in satisfying or meeting the needs of customers.
Churned ARR= Total annual recurring revenue lost from existing customers.
- Contraction ARR: Contraction ARR is the total reduction in ARR because of downgrades and cancellations from existing customers. If your contraction ARR is high, that means customers are canceling their subscriptions, or, in other words, churning. Customers downgrading to lower plans don’t find value in your higher-priced plan.
Contraction ARR= (Downgrade MRR + Cancellation MRR) x 12
Why is ARR important for your business?
Whether you are planning an expansion, re-evaluating product-market fit, or evaluating trends, Annual Recurring Revenue helps provide a clear picture of how your SaaS business measures up to those of other businesses. You can collect numbers all day, but the numbers won’t unravel a story before you can decipher what they mean.
Understanding ARR is crucial for several reasons:
1. Investor’s appeal
Historically, investors have always considered the ARR growth rate as an important metric for assessing the growth potential of a SaaS business. A higher ARR growth rate means higher valuation and a lower growth rate means lower valuation.
For instance, in Q1 2024, publicly traded SaaS companies are trading at as high as 10.3x ARR. That means the company valuation is ARR multiplied by 10.3.
As a SaaS CFO or founder, ARR numbers paint a bleak picture of how they should respond to these growth trends so you can fundraise better.
2. ARR allows you to forecast future revenue
You’re not a fortune teller, but a strong understanding of your ARR value can help you estimate how much money your subscription business will make over a certain period.
There are three elements that contribute to how much your ARR will change relative to your previous year:
- New ARR
- Churned ARR
- Expansion ARR
We recommend you track these using a chart similar to the one below:
This chart shows three components of ARR bookings: New ARR, Churned ARR, and Expansion ARR. By breaking down each component, you can track key elements that drive the growth of your business. Through this, you can easily build a reasonable picture of what success looks like in the future.
Without ARR, you will never be able to understand the real customer impact of the decisions you make for the company.
3. ARR shows your business’s financial health
At its core, ARR represents the predictable and recurring revenue generated by a SaaS company for a subscription-based product or service, calculated over a period of 12 months.
You can think of ARR as the financial heartbeat of a SaaS company–it's a clear indicator of the growth and stability of the business.
For CFOs, ARR goes beyond a mere accounting figure. It provides insights into customer loyalty, retention, and growth potential. For investors, ARR is a yardstick for measuring a business's financial health and its potential for future growth.
4. ARR is connected to tons of other subscription-based metrics
Annual Recurring Revenue is a hero value for many other SaaS metrics. It will offer you different ways of looking at the performance of your business.
Here are some metrics that can be calculated using ARR:
- Monthly Recurring Revenue (MRR)= This is the monthly equivalent of ARR, calculated by dividing ARR by 12.
MRR = ARR / 12
- Customer Acquisition Cost (CAC): This measures the cost of acquiring a new customer.
CAC = Total Cost of Customer Acquisition / Number of New Customers
- Customer Lifetime Value (CLV): This is the total value a customer is expected to bring to a business over their lifetime.
CLV = ARR * Average Customer Lifetime
- Gross Margin: This is the difference between revenue and the cost of goods sold. It is calculated by subtracting the cost of goods sold from ARR.
Gross Margin = ARR - Cost of Goods Sold
Besides these, ARR is also helpful in calculating customer retention rate, churn rate, and expansion rate.
How to optimize Annual Recurring Revenue (ARR)?
There are only three ways you can increase your Annual Recurring Revenue:
- Increase new user count
- Increase average revenue per account
- Reduce churn
All of your actions should ultimately result in boosting any of the following goals. Here are some ways you can optimize your efforts to achieve higher annual recurring revenue:
- Enhance your marketing and sales efforts to reach a wider audience and generate more leads. Understand your customers' pain points and ensure that your product offering can solve those problems.
- Focus on add-ons and upsell instead of discounts and incentives to increase your average order value in the long term.
- Another way to attract new customers is to develop new products that will attract existing and new customers to upgrade or subscribe to additional services.
- Leverage technology and automation to remove any repetitive tasks. This would free up resources for more strategic efforts.
- Review and adjust your pricing strategy to align better customer value expectations from your product.
Make measuring Annual Recurring Revenue a priority for your SaaS business
Remember, ARR is a metric that requires continuous monitoring. You can confidently make decisions based on the subscription landscape by actively using ARR to guide your strategies. This helps outshine your competitors and set a path for long-term success.
Zenskar makes it easy to track the Annual Recurring Revenue metric by integrating all your critical systems of record, EPQ, ERP, and billing systems. The platform also lets you continuously monitor your customer's billing/usage throughout the billing period.
Curious to learn more? Book a demo, and we'll show you how Zenskar can automate revenue recognition.
Frequently Asked Questions (FAQs)
1. How do you track ARR?
Annual Recurring Revenue is calculated by adding all recurring revenue and subscriptions and subtracting lost revenue.
The ARR formula is:
(Total revenue from new subscriptions during the period) + (Recurring Revenue from existing subscriptions at the start of the period)
- (Churned revenue from existing client contracts during the period)
+ (Upgrades or downgrades from existing subscriptions during the period)
2. Why is ARR important for SaaS?
ARR is one of the most important metrics for subscription-based businesses as it helps forecast future revenue, quantify growth, and determine customer retention, acquisition, and cancellation trends.
3. How do you increase ARR?
SaaS businesses can optimize their ARR by increasing new user count, expanding average revenue per account, and reducing churn.
