The Retainable Guide To: Annual Recurring Revenue
Annual Recurring Revenue is a key metric for subscription businesses, stating the recurring revenue normalized for a one year period. It is a great metric to measure momentum of a business over time, as ideally a business owner will see Annual Recurring Revenue move up and to the right.
Let’s learn more about it, and how it is calculated, here:
What Is Annual Recurring Revenue?
Annual Recurring Revenue, often referred to as ARR, is the recurring revenue a subscription business receives, normalized to a one year period. It is the same concept as Monthly Recurring Revenue, except for the obvious difference of the time frame–annual vs. monthly.
For example, if you have a customer who signs a 2 year contract for $20,000, then the Annual Recurring Revenue from that customer is $20,000/2 years = $10,000 ARR. You are normalizing revenue for a 12 month period, and counting all recurring revenue over that one year period to arrive at Annual Recurring Revenue.
Why Is ARR Important?
Annual Recurring Revenue is an important metric to track the overall health and trends of your business. Your ARR will be constantly in flux (ideally up and to the right). Are you on a growth trajectory, relatively flat, or declining? What is the speed of that growth acceleration or deceleration? These are questions that you will see from your ARR figures.
From there, your ARR trends will be critical to planning and forecasting, so that you can wisely manage expenses, investments in growth, and resources overall.
How To Calculate Annual Recurring Revenue
The same principles of calculating Monthly Recurring Revenue applies to Annual Recurring Revenue.
To calculate your Annual Recurring Revenue, you can use the following formula:
Calculating ARR from MRR
It is a logical conclusion for SaaS companies to calculate an Annual Recurring Revenue from multiplying Monthly Recurring Revenue by 12. This is straightforward as a quick proxy to get trends over time, and monitor how ARR has trended.
The drawback to calculating Annual Recurring Revenue from Monthly Recurring Revenue is that it assumes that customers will remain as paying customers for at least 12 months. For SaaS companies that have 8.33% monthly churn or less (100% of customers divided by 12 months = 8.33% churn per month), customers will be paying customers for over a year. However, that is not always the case, and that is the reason that extrapolating ARR from MRR can have faulty assumptions.
Thus, it is most accurate to only calculate ARR from contracts that have a minimum of one year.
Enterprise SaaS companies tend have more annual contracts, so the certainty of generating annual recurring revenue is better than those companies in which a customer can cancel in any given month.
What To Exclude In ARR Calculations:
In order to accurately calculate an Annual Recurring Revenue, there are some things that must be excluded. They are as follows:
- One Time Fees and non-recurring revenue: this could include one-off consulting fees, implementation fees, onboarding fees, etc. If it can not be counted as revenue that will be predictable in the future as a recurring revenue source, then it must be excluded in this calculation.
- Discounts: If a customer is on a subscription plan that is discounted, only the actual revenue can be counted towards ARR. For example, assume a customer is on an annual contract that is discounted from $20,000 a year to $15,000 per year. The ARR contribution from this customer would be $15,000. Any changes to the plan type would be accounted for in future ARR calculations.
- Free trials: Similarly, customers who are on free trials should not be counted in ARR calculations. Once they become paying customers, then their revenue counts towards ARR.
The Simple Way To Calculate ARR
However, understanding the mechanics behind the ARR figure is very important in highlighting the factors at play that impact ARR.
Now you have a solid understanding of Annual Recurring Revenue, why it is important, and how to calculate it.
Tracking your ARR on a regular basis is something that you will naturally do to monitor the health of your business and observe growth trends over time.
From there, you will be far more informed in understanding the nuances of your business, the goals that you are setting, and the levers that can drive future growth.
The logical next step is to grow your ARR! We will cover the strategies of growing your subscription revenue in future content, so stay tuned!