Table of Contents
Key takeaways:
- Annual recurring revenue (ARR) is a vital SaaS metric that helps you track annual forecasted revenue
- Calculate ARR by adding the value of annual contracts and upgrades, and subtracting out the lost revenue from cancellations and downgrades
- ARR can provide critical insight into your business that can help you forecast your future financial situation, make strategic investment decisions, and more
SaaS companies generate their revenue from the subscription payments that customers pay for using their software.
The eventual profit of a SaaS organization is the difference between the subscription revenue and the cost incurred in doing the above-mentioned activities.
As with any business, there are specific metrics that help management run organizations and track the progress toward their target. Luckily, there's also software to help track, analyze, and make the most of these data points and insights.
Understanding Annual Recurring Revenue
Annual recurring revenue, as the name suggests, is the total forecasted annual revenue of a SaaS company based on the subscription contracts it has garnered. It only measures the income that is guaranteed and excludes all one-time or trial subscriptions.
This means ARR is generally calculated based on year-long or multi-year contracts. Even if the payment is made on a month-to-month basis, if there is a contractual arrangement or auto-renewal agreement, then the revenue forecasted is included in ARR.
That said, the calculations vary from business to business, and some organizations include all clients that they are reasonably sure will be retained. The critical element is that ARR considers the churn of customers and hence can be a good indicator of revenue retention.
How to Calculate ARR
ARR is calculated by considering the total amount of yearly subscriptions, the number of yearly upgrades committed, and the number of cancellations.
The formula for calculating ARR is as follows:
ARR = (Revenue from yearly subscriptions normalized for a year + Revenue from recurring upgrades for the rest of the year) - Revenue lost from cancellations
ARR Calculation Example
For example, if you have three customers that have agreed to buy the subscription at $10 per month, then the revenue from yearly subscription revenue normalized for the year is 3 ✕ $10 ✕ 12 = $360.
Now, imagine that one customer upgraded to a pro membership for an extra $2 per month in March. The second element of ARR, the revenue from recurring upgrades for the rest of the year, becomes $2 ✕ 9 where 9 is the remaining number of months.
Similarly, if a customer canceled their subscription, then the third element, the revenue lost from cancellation, becomes $10 ✕ 12 = $120.
The ARR is thus $360 + $18 − $120 = $258.
How essential is ARR in measuring business success?
For a company that sells its products or services based on subscriptions, ARR is a critical metric that tells the story of its whole business model. Let’s explore why it is essential in measuring business success.
1. Provides a Clear Look at Revenue Trends
ARR takes into consideration all the existing customers of the company that the organization is confident they will retain. This means it provides a reasonably accurate assessment of the current state of the business. Only an unforeseen circumstance with disastrous effects on the company’s infrastructure or service-providing abilities would trigger a change in the state deduced via ARR.
2. Improves Profit Forecasting
ARR helps organizations forecast their profit for the entire year ahead. ARR can be considered as the minimum revenue the company will get even if it does not win any new clients or upgrades for the rest of the year, so it helps the organization to set a baseline for their revenue forecasts.
3. Validates the Business Model
The whole point of a subscription business model is hoping that people will continue to pay for its services for the foreseeable future. ARR helps in asserting this and gives an indication to the management of whether the subscription business model is a viable alternative in that specific domain.
4. Provides Product Performance Insights
ARR considers only subscription revenue. In that sense, it is different from total revenue, which may include other sources of income such as one-time payments or add-on products, so it helps management focus only on specific products and the customers that use that product. It is also possible to calculate the ARR of individual products if the company has multiple products in its portfolio.
5. Facilitates Strategic Decision-Making
As mentioned above, ARR denotes the minimum revenue the company can garner in that year. Hence, it plays an important role in deciding how much money can be spent on product features, sales promotions, employee appraisals, and more,etc. You can leverage metrics like ARR and growth rate to make smart investments in your business, ensuring that you maintain a reasonable burn rate and avoid cash flow concerns
When to Track ARR
ARR should only be used by organizations that earn most of their revenue from subscriptions. Such organizations generally run based on customer relationships, and the churn of customers is a big factor in the business’s success. Using ARR for measuring business success only makes sense in organizations that meet the following conditions.
- Your organization gets the majority of its revenue from subscription-based products. If only a small percentage of your revenue comes from SaaS products, using ARR will distort your company’s real status.
- Your organization provides a year-long contract or autorenewal-based subscription setting. If your company runs primarily based on short-term contracts, using ARR may be tricky because you cannot predict with reasonable accuracy whether your customers will renew until the end of the year. ARR cannot be used in such cases as an indicator to decide budget allocations. In such cases, Monthly Recurring Revenue (MRR) may be a better indicator.
- Your contract with customers states that they cannot cancel without giving a sufficient notice period. If customers can cancel at will, even though the contract is at least one year long, using ARR might cause confusion. Some organizations, especially ones with large contract values, allow customers to cancel midway and only mention price protection in their year-long contract arrangements.
- You want a metric that can provide the potential value of your business to investors even before the financial year ends or outside the Generally Accepted Accounting Principles (GAAP).
- Your business model does not include too many one-time payments, add-ons, or auxiliary services that can contaminate the ARR metric. These one-time payments and upgrades are generally not included in ARR, but they will be included in total revenue. If your business relies on these one-time payments more than subscription revenues, you are better off using absolute revenue rather than recurring revenue metrics.
- Your decision-making horizon is less than a year and you want to make budgeting decisions based on expected revenue. If your budget allocation happens once a year, you are better off using metrics based on GAAP.
- You are focused on retaining customers as well as gaining customers. ARR is an excellent measure to track the loyalty of your customers.
Baremetrics provides an easy-to-read dashboard that gives you all the key metrics for your business, including:
- MRR
- ARR
- Time to Value
- LTV
- total customers
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How to Leverage ARR to Improve Business Outcomes
Since ARR provides an accurate picture of the health of a company, it can be used in many ways to improve business outcomes.
1. Attracting Investors
Since ARR gives a real-time metric about the health of your business, it is very valuable when you are trying to get investors to grow your organization. If your business is predominantly subscription-based, investors only need to look at this single metric to get an idea about your current status. A cursory look into how your ARR has varied over a period of time will give investors all the information they need to assess your potential.
2. Planning Product & Business Growth
ARR provides an accurate forecast of how a company’s finances will look in a year’s time. Hence, it gives senior management visibility into how much money is available for product development and allows them to plan the feature rollouts to prioritize the most loyal or tentative customers depending on the circumstances. Similarly, you can also allocate forecasted revenue into business growth investments, including scaling up marketing or sales efforts.
3. Setting Realistic Goals
ARR helps set goals that are achievable but not too easy at the same time. An organization with a low ARR has infinite potential to grow, and the senior management can pursue aggressive growth targets. On the other hand, an organization that already has a high ARR like Netflix or Amazon Prime can only grow them at a lower rate. Managers can prioritize steady growth vs. risky aggressive growth based on the current value of ARR and how it has varied.
4. Motivating the Sales Teams
Variation of ARR over a period of time gives you an idea about how well your sales team is performing. You can even analyze ARR in a granular way to find out which sales group brings in the most revenue or has the highest ARR. A positive change in ARR can be incentivized as a good motivational metric for the sales team.
5. Retaining Employees
Recurring revenue calculations help to determine the budget that you have access to even before the annual or quarterly reports are out. Offering raises at critical times is a key element of retaining employees. Having access to real-time ARR helps you make quick budgeting decisions to retain your star employees.
Other supporting metrics
As evident from above, it is very difficult to accommodate cancellations that happen in the middle of the year in ARR. So, ARR is best used when you have reasonable confidence in the contracts signed by your customers. An alternative that can be considered here is MRR, which is better when most of your contracts are short term.
Other than ARR and MRR, there are many relevant metrics that can help in measuring the success of a SaaS business. Customer Lifetime Value (LTV) is a key metric that can help in knowing your customers better and deciding which ones are worth your attention. It is calculated by multiplying the annual revenue by the average customer lifetime. Another metric is the Customer Acquisition Cost (CAC), which indicates how much the company needs to spend on average to onboard one customer.
Conclusion
The key to succeeding in business is measuring the current state and setting realistic goals. Metrics like ARR are an important part of that puzzle.
The smart analytics tools provided by Baremetrics help you uncover these metrics and their meaning from the information you already have. Intuitive dashboards help management to better understand their products, sales teams, and customers.
Tired of wasting time on spreadsheets? Get a free trial of Baremetrics today!
