When it comes to measuring the financial health of subscription businesses, one metric will come up in conversation time and again: Annual Recurring Revenue (ARR).
ARR is popular for a reason—it allows you to track growth, understand revenue, and plan for the future.
Let's delve deeper into what ARR is, how it's calculated, and why it's so important.
What is ARR?
ARR, or Annual Recurring Revenue, is the total amount of subscription revenue that a company is expected to earn from all customers over a one-year period. It’s the combination of yearly recurring revenue including subscriptions, add-ons, and upgrades minus revenue lost from cancellations and downgrades during the year.
Some organizations may further break this down into Monthly Recurring Revenue (MRR), but ARR provides a broader perspective on revenues and expenditures.
How to Calculate ARR
To calculate ARR, you need to account for all recurring subscriptions, upgraded accounts, downgraded accounts and lost revenue from churned customers. You might have to go to multiple different systems depending on your tech stack.
Once you’ve got the data compiled, it’s as simple as subtracting any lost profits due to cancellations from the revenue generated through subscription renewals and upgrades payments each year.
Here's a simple formula: ARR = (Total Annual Subscriptions + Upgrades - Downgrades - Churn)
What Not to Include in ARR Calculations
When calculating ARR, it's important to exclude certain factors that could skew your results.
These include set-up fees, account adjustments, discounts, one-off upgrades, and any other non-recurring charges. These variables don’t contribute to recurring revenue and thus should not be factored into ARR calculations in order to maintain accuracy.
Miscalculations can lead you and your investors to misunderstand the health and potential of your subscription revenue, which can cause you to be either overfunded (and equity poor) or under-resourced (and unable to expand) for the year ahead.
Why Understanding Your ARR is Important
Understanding your Annual Recurring Revenue (ARR) is not just a check-every-once-in-a-while metric—it's fundamental to the long-term success of your business. Every subscription-based business should be tracking ARR for several reasons:
Assessing Long-term Financial Health
ARR is an indicator of your business's financial well-being, as it provides a top level view of the revenue you can expect to generate over the course of a year.
By tracking ARR on a regular basis, you can gain insights into your company's financial trajectory and stability.
For example, if your ARR is consistently growing, it indicates that your business is expanding and generating more recurring revenue. On the other hand, a declining ARR may signal a need for strategic adjustments to stem customer churn or increase subscription renewals.
Measuring Effectiveness of Pricing
The effectiveness of your subscription model can be gauged through the lens of ARR. It shows you what's working - and what isn't - in your current approach.
For instance, if you introduce a new pricing tier and see an increase in ARR, it suggests that the new tier is attracting customers and inspiring upgrades. On the other hand if your ARR dips after implementing certain changes, it might be a sign that you need to go back to the drawing board.
Better Decision making
Accurate ARR numbers can help drive many business decisions about pricing, marketing initiatives, or product development. Should your ARR growth slow down for instance, it might be time to revisit your pricing strategy or ramp up marketing efforts to attract new customers. Similarly, if a particular product feature is driving upgrades (and thus increasing ARR), it could be worthwhile to invest more in developing that feature.
As a measure of a company's growth, ARR is unmatched in its ability to provide a clear indication of revenue predictability and business expansion.
By comparing your ARR from one year to the next, you can track your growth rate and set realistic goals for the future. You might use this year's ARR growth rate as a benchmark as your organization aims for a similar or higher growth rate next year.
ARR vs. MRR and Other Metrics
While ARR and MRR (monthly recurring revenue) both focus on recurring revenue, they differ in their scope. ARR offers a yearly view, while MRR provides insights into monthly income.
Both are essential for forecasting revenue, but ARR offers a more comprehensive view of long-term growth. If you’re looking for a breakdown of the different types of metrics every SaaS subscription business should be tracking, check out our Little Black Book of SaaS
Monitoring your ARR is crucial for guiding your subscription business towards success. It offers a clear picture of your financial status, measures the effectiveness of your business model, and provides valuable insights for decision-making and growth tracking.
If you're having trouble tracking your SaaS metrics in real-time, consider using a service like Place’s Metrics & Analytics product. With over 200 flexible metrics, reports, and dashboards, it's an indispensable tool for any SaaS CEO. By providing live, connected data, you can easily understand and share metrics like Burn Multiple, CAC:LTV, NDR, and even forecast future metrics.
Understanding ARR is just the beginning. Getting a grasp on important SaaS metrics can guide your company toward sustainable growth.