What is Annual Recurring Revenue?

Annual Recurring Revenue (ARR) is defined as an important metric that tells SaaS or subscription businesses how much revenue they can expect to generate from their subscribers every year.

ARR is the amount of revenue that a business expects to generate every year on a recurring basis. Recurring revenue is probably the most salient feature of the subscription model. Annual Recurring Revenue gives you an overview of the performance of the business on a year over year basis.

Importance of ARR

ARR is a key metric to understand two aspects of a subscription company or SaaS business's revenue:

  • Revenue gained due to new sales and upgrades (expansion revenue)

  • Revenue lost due to customer churn and downgrades

When measured correctly, ARR is a good indicator of your business's health and forecasting future revenue.

ARR also adds essential context for other metrics. For example, say you have a churn rate of 4%. Is that reason to worry? Or is it acceptable? But when you look at the churn in a bigger picture with the ARR factored in, you know if it is reason enough to worry.

Investors love the predictable revenue that the subscription business model allows. So growing SaaS companies with a healthy stream of ARR stand a better chance at attracting more investors and keeping the board members satisfied.

How Do You Calculate Annual Recurring Revenue?

It is fairly simple to calculate ARR. Here's the formula and everything you need to know about it. You can calculate ARR as follows:

ARR = Sum (Yearly Recurring Charge of all paying customers)

If you bill your customers monthly, you can calculate ARR as:

ARR = (Contract Value) x (12/ Duration of contract in months)

For example, if a customer signs a 3-year contract (36 months) for $60,000, which is billed monthly, your ARR calculation is:

ARR= $60,000 x (12/36) = $20,000.

If you bill your customers annually, you can calculate ARR as:

ARR = (Contract Value) / (Duration of contract in years)

For example, if a customer signs an annual contract for two years at $40,000, your ARR calculation is:

ARR= $40,000/2 = $20,000.

While this seems relatively straightforward, it is important to know whether all the charges included in the contract value are 'recurring'.

Elements to be Included in ARR Calculation

Since ARR is a calculation of all recurring subscription charges in a given period, you need to include the following elements in the ARR calculation:

  • Recurring invoices: It covers all recurring subscription revenue, including recurring fees such as recurring subscription charges per user or seat.

  • Upgrade revenue: When a customer moves from a lower value plan to a higher value plan, mostly due to an upsell, it increases the customer's recurring revenue. Hence you also need to include upgrade revenue in your ARR calculation.

  • Downgrade revenue: In a scenario when a customer moves to a lower value plan from a higher value plan, it results in MRR churn. It is essential to include it in ARR calculations as it reduces the recurring revenue from that customer.

Elements to be Excluded in ARR Calculation

ARR is a forward-looking metric and tells you how much revenue you can expect. Naturally, you don't have to include elements of non-recurring nature in the ARR calculation. These elements are:

  • One-time fees

  • Set-up fees

  • Non-recurring add-ons

The Difference between ARR and MRR

Monthly Recurring Revenue (MRR) is the predictable recurring revenue earned from subscriptions in a particular month. There are several different types of MRR, such as new MRR, upgrade MRR, expansion MRR, and contraction MRR. This level of detail and segregation gives useful insights on a monthly basis. For businesses that offer yearly subscription contracts, tracking ARR makes more sense.

That being said, it is never an either/or situation when it comes to ARR and MRR, as the former gives a long-term picture while the latter offers short-term insights.

Common Pitfalls to Avoid in Interpreting ARR

1. Mistaking ARR for Cash

ARR is not the same as cash. Let's understand with the same example as we did above. A customer signs an annual contract for two years at $40,000.

In this scenario, the ARR is $20,000. 

But, assuming an upfront payment, cash is $40,000.

Mistaking ARR for cash can create a falsified image of how much money a business has.

2. Looking Backward, Not Forward

Another common mistake is when businesses calculate ARR by adding up the total revenue for the last 12 months. But in reality, ARR is a forward-looking metric, and it takes into account how much revenue you can expect in the future, not how much you generated last year.

3. Not Accounting for Discounts

If you have given your customers discounts or coupons, that means they are not paying the full price of the subscription. It is essential to account for the discounts when calculating ARR. For example, if the annual subscription value is $10,000 with a 20% discount, the customer is only paying $8000, and only that should be considered for ARR calculation.

4. Not Including Late Payments

Every business has delinquent customers. You can keep late payments under check by implementing a dunning mechanism, but when the late dollar amounts come rolling in, remember to include them in your ARR calculations.