What is Annual Recurring Revenue and why is it important?
When growing a SaaS business, it is essential to use a subscription-based revenue model. This business model has the advantage of ensuring regular revenue once a customer has subscribed to a service. And, this is useful for planning the future of a business, and reassuring investors.
Annual recurring revenue (ARR) is a business metric designed for subscription-based companies. It allows them to forecast their company's future revenues and calculate the rate at which they need to grow to keep building on their success.
Here is a complete guide on what is Annual Recurring Revenue and how to calculate it.
What is Annual Recurring Revenue?
Annual Recurring Revenue or ARR is a business metric that predicts the revenue a business can expect, based on yearly subscriptions.
It is primarily used by subscription businesses such as SaaS (software as a service) vendors.
How to calculate ARR
Before calculating your annual recurring revenue, you must have the following requirements:
- sell subscriptions plans that are a minimum of one-year (and ideally several years),
- exclude non-recurring revenues, expenses and charges.
💡If your business model is based on subscription plans that are less than one year (3 months, 6 months, etc.), it would be wiser to calculate the MRR (monthly recurring revenue)
The monthly recurring revenue can also be used to calculate the ARR as we will see later on.
Calculating ARR: a simple formula?
Let's say that you are selling a SaaS software with a one-year subscription that costs 1,000 dollars per month. If 10 customers subscribe, the ARR for the year is 120,000 dollars:
ARR = number of customers x cost of the annual subscription
This is the easy way to calculate your ARR.
But, in reality, businesses are more dynamic and complex. From unsubscriptions to additional sales, recurring revenues are likely to fluctuate a lot.
Therefore, if you want to forecast revenue in a feasible way, you will have to make some adjustments by taking into account other metrics.
Metrics that should be taken into account
For SaaS companies, it generally takes longer to make the sometimes high acquisition costs profitable, and customer retention is critical to generating profits.
It is therefore essential to monitor your business as closely as possible with KPIs.
The monthly recurring revenue (MRR) of new customers
⏺ One of your priorities is to acquire new customers every month. Based on your past results or your forecasts, identify the number of new clients per month and the associated MRR.
👉Feel free to update this figure regularly based on the actual number of customers you attained.
Expansion of the MRR
⏺ You must consider additional recurring revenue. For example, when your customers switch from a basic subscription to a premium subscription that is more expensive.
Estimate the percentage of your customers who switch to a higher subscription each month. This gives you a good target to reach.
👉 Example: Every month, 10% of your customer base moves from a basic subscription of $1,000/month to a premium subscription of $2,000/month in the fourth month of their first subscription. Here's how to take this into account
MRR for the first 3 months: $1,000 x 10 customers x 3 months = $30,000
MRR for the next 9 months (basic): $1,000 x 9 clients x 9 months = $81,000
MRR for the next 9 months (premium): $2,000 x 1 client x 9 months = $18,000
ARR = $ 129 000
Now you realize how much switching to a premium subscription early affects the value of the ARR. Moreover, it makes revenue increase without increasing customer acquisition costs, with a higher net margin.
Declines of MRR
⏺ Sometimes, new customers take advantage of a discounted welcome offer to subscribe to your services. This loss of revenue must, therefore, be taken into account in the calculations.
👉You should also consider that some customers may switch from a premium offer to a cheaper offer.
The churn rate (or attrition rate)
⏺ Today, customer churn is a concern for most businesses at one point or another. And, the churn rate must be taken into account when forecasting future revenues, because is intrinsically linked to the ARR.
👉 Use your actual attrition rate as a guide, or if you are starting your business, make an estimate after carrying out market research (for example, you can estimate that you are losing 10% of your customers every 3 months).
Annual Recurring Revenue formula
The ARR formula
ARR= Revenue from annual subscriptions + Other recurring revenue* - Losses due to unsubscriptions
*additional recurring sales, subscriptions at a higher subscription level
Calculating the ARR by using the MRR
Just like its name implies, the MRR (monthly recurring revenue), measures recurring revenue over a month.
How to calculate the ARR
MRR= Monthly subscription revenue + Revenue from new customers + Other recurring revenue - Losses due to subscription changes- Losses due to unsubscriptions
👉 ARR = MRR x 12
Why should you calculate annual recurring revenue?
To make decisions
The ARR allows you to make a realistic forecast of where your business will be in the near future. Combined with the metrics mentioned above and the average duration of a subscription (lifetime value) for example, you will have a better vision of the real value of a customer and will be able to make the right strategic and operational decisions. Moreover, as the ARR focuses on the present, a negative variation can serve as a warning and allow you to react quickly.
To set realistic goals
The ARR is both realistic and predictive, helps to provide context and shed light on the definition of the objectives to be achieved. We know that a good objective is a SMART (Specific, Measurable, Attainable, Realistic and Time-bound) objective and that a SMART objective maximizes the chances of success of a project or business.
To monitor the growth of your business
If subscriptions are the main foundation of your business model, an increase in your ARR indicates that:
- there are more subscriptions,
- or more recurring sales, and therefore a growing business.
To convince investors
Revenue stability is highly appreciated by investors, and the annual recurring revenue offers a certain guarantee of return on investment. In addition, it makes it possible to predict how future revenue will increase. Moreover, the RRA is a metric that can be highlighted in a business plan or a cash flow plan.
Are ARR and MRR indicators of profitability?
As you have seen, the ARR is a key business metric that can be used to measure the recurring revenue generated by your customers and to predict the amount of turnover at the end of the year.
Its accuracy and effectiveness are enhanced when fluctuations (increases and decreases) in recurring revenues and unsubscriptions are taken into account, providing a realistic view of the revenue mix in the future.
However, you should not view this as an indicator of your company's profitability and financial health. The ARR does not take into account the customer acquisition cost, which is often high for SaaS companies, and the various expenses inherent to the business.
Your ARR may do very well, but your customers may not generate enough value to generate a net margin.
In fact, that's the crux of the matter: reducing customer acquisition costs over time so that they generate value faster, retaining them as a source of revenue for as long as possible, and ideally enchanting their experience so that they can multiply that value by subscribing to a premium package.
What about you? Does your business measure annual recurring revenue?