The inception of cloud-based SaaS businesses has greatly changed the business landscape. Software programs no longer have to be sold on a one-time sales license.

 

A typical SaaS company charges monthly or annual subscriptions for its services. This subscription revenue goes toward maintaining the company’s infrastructure, marketing the product to new customers, and developing new features.

 

The eventual profit of a subscription business is the difference between the subscription revenue and the costs above.

As with any other organization, a subscription company needs to use some metrics to keep track of its progress toward achieving its target. This article looks at Annual Recurring Revenue (ARR). Keep reading to learn how to calculate Annual Recurring Revenue and how it helps your subscription business.

 

What Is ARR?

Annual recurring revenue (ARR) is a metric used by SaaS or subscription businesses to show the income that comes at the end of every year of the subscription or contract.

 

Simply put, ARR is the contractually obligated revenue normalized to a year. Therefore, if you buy a two-year subscription for $14000, the ARR is $7000.

 

Why Is Measuring ARR Important?

ARR is one of the most important metrics for subscription-based companies because it gives a clear picture of business performance. Let’s look at why you should measure your business’s ARR.

 

It Provides a Numeric Measure of Business Health

ARR calculations consider the business’s existing customers that it’s confident it will retain. Therefore, this provides a vivid idea of how healthy the business is.

 

Only an unprecedented and unfortunate event would affect the business model enough to trigger a change in the state deduced via ARR calculations.

 

It Helps Forecast Profit

ARR can be described as the least profit a business will earn if it doesn’t earn new sales in the next year. So it helps the company forecast revenue and set the baseline for its operations.

 

In this article, we’ll break down the basics of ARR so you have a better understanding of recurring revenue.

 

 

It Helps Validate the Business Model

The main goal of a subscription-based business model is to get customers to keep paying for the services continuously into the foreseeable future.

 

Calculating ARR helps the business evaluate the business model’s success and decide whether subscription-based services are viable in that domain.

 

It Helps the Subscription Business Make Investment Decisions

As mentioned above, the ARR calculation evaluates the least amount of money that can be made in the next year. Therefore, it plays an essential role in planning how much money can be spent on employee appraisals, product features, and sales promotions.

 

It Helps Understand Specific Products Better

The ARR calculation only considers subscriber purchases and sets the revenue aside from other sources that may include one-time sales or add-on products.

 

Therefore, it helps concentrate on specific products and their customers. Calculating ARR for specific products is also possible if a company has multiple subscription products.

 

Where Is It Advisable to Use ARR?

Image: Couple watching Netflix (source)

 

ARR is best for companies that make most of their revenue from customer subscriptions. These organizations heavily rely on customer relationships, and customer churn is a huge factor in the business’s success.

 

Using ARR to measure a business’s success is only sensible if the company meets the following requirements.

 

1. If the organization makes most of its total revenue from subscription-based products. If only a small percentage of the revenue comes from customer subscriptions, ARR may distort the company’s real status.
2. If the organization provides yearly subscriptions or renewal-based products. If the company runs short-term contracts, using ARR may not be completely accurate because it’s impossible to know if your customers will renew their subscriptions till the end of the year. In such instances, MRR (Monthly Recurring Revenue) is better suited.
3. If the company’s contract with customers states that they can’t cancel without giving an adequate notice period. Otherwise, if the company allows customers to cancel their contracts at any time, it can lead to confusion in the ARR calculation.
4. If the company needs a metric that can prove its potential value to investors before the end of a financial year or outside the Generally Accepted Accounting Principles (GAAP).
5. The business only uses a subscription model and doesn’t accept too many additional products, one-time fees, or auxiliary services that may contaminate the ARR. If the business has a mixture of products or many one-time licenses, it’s better to use absolute revenue than recurring revenue metrics.
6. If the company’s decision-making horizon is less than a year. If the business allocates its budget more than once a year, it’s better to use GAAP metrics.
7. If the business is focused on retaining and gaining new customers. ARR is an excellent metric to gauge the loyalty of customers based on how long they keep their subscriptions.

 

How Can Annual Recurring Revenue Be Used to Improve Business Outcomes?

Since ARR is an accurate business health metric, it can improve business outcomes in several ways.

 

Planning Product Development

ARR gives a rough indication of how a business’s income will look in a year. This allows senior management to allocate a section of the budget to product management and plan for new feature rollouts prioritizing the most loyal or tentative customers.

 

Attracting Investors

ARR is an accurate business health metric. Therefore, you can use it when you’re trying to get investors to grow the business.

 

If the business only uses a subscription-based model, investors only need to look at the ARR to know how it’s doing financially. A cursory look into the business’s ARR will also give the investors a look into how the business has progressed and help them forecast future growth.

 

Setting Realistic Goals

Image: People brainstorming in a boardroom (source)

The ARR calculation helps a company set high but realistic goals. A company with a low ARR has infinite growth potential and can set aggressive growth targets.

 

On the other hand, a company with a high ARR, like Amazon or Netflix, can only grow at a lower rate. Therefore, the management can use steady growth instead of aggressive growth.

 

How to Calculate ARR

To achieve all the benefits above, you must know how to calculate ARR. ARR is calculated based on the total number of yearly subscriptions, the number of cancellations, and yearly upgrades committed.

 

The formula is as follows:

 

ARR = Total revenue from contracts or yearly subscriptions normalized to a year + revenue from recurring upgrades for the rest of the year – revenue lost to planned cancellations.

 

For instance, if you have five customers paying $10 monthly subscriptions for a year, the yearly subscription revenue normalized for a year is $5 × 10 × 12 = $600.

 

Imagine one customer upgrading their subscription for $2 per month in March. That is $2 × 9= $18.

 

Similarly, if one customer cancels their subscription, you need to deduct their total contract value, that’s $12 × 10 = $120.

 

Therefore, the company’s ARR is $600 + $18- $120 = $258.

 

Bottom Line

Annual Recurring Revenue (ARR) is an important metric to measure the health of any subscription-based business. It is suitable for businesses with multi-year contracts and SaaS companies that offer subscription-based products.

 

Hopefully, the tips above can help you decide if ARR calculation is ideal for your organization.

 

To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.