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What is Annual Recurring Revenue (ARR)? How to Calculate It
Belal Batrawy
Founder, learntosell.io
While nothing is certain these days, it’s nice to have a reliable income stream. The subscription model — monthly or annual recurring revenue for products or services — helps businesses rely on deposits consistently being made directly into the company checking account, month after month and year after year.
But what, exactly, is annual recurring revenue — and how can it help your bottom line? Read on to learn more how revenue management software can help.
What is annual recurring revenue (ARR)?
Annual recurring revenue (ARR) is predictable and consistent revenue derived from a company's products and services, projected over one year. Companies that offer annual subscriptions use this sales metric to determine expected yearly revenue.
ARR is frequently used by companies that offer a software as a service (SaaS) model. It is also equally useful for streaming services, mobile phone bills and almost any product or service that has consistent, predictable charges.
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How to calculate annual recurring revenue
Use these three steps to calculate ARR:
- Add up the total revenue from annual subscriptions for your products and services.
- Add up the total amount of additional ongoing revenue (things like maintenance and support).
- Subtract the total amount lost through subscription cancellations (otherwise known as customer churn).
Here's the formula:
Annual subscriptions + additional ongoing revenue - cancellations = ARR
For example, an SaaS company has annual subscriptions of $10 million. The company has additional revenue of $1 million for maintenance fees. It loses about 2% of customers every year or $200,000.
Here's how it looks as a formula:
$10,000,000 + $1,000,000 - $200,000 = $10,800,000
If your products or services are sold via a monthly subscription, you can use the same formula. However, first multiply the monthly recurring revenue by 12.
To drill down further and get a clearer picture of how your sales strategy works, break down the ARR formula into these components:
- Revenue added from new customers
- Revenue added from renewals
- Revenue added from upgrades
- Revenue lost from downgrades
Let's say the same SaaS company had additional revenue of $500,000 annually from new customers.
Here's how it looks as a formula:
$10,800,000 + $500,000 = $11,300,000
Note that for an SaaS company, the ARR should include the subscription fees for the service along with additional fees for things like ongoing maintenance and support. ARR refers to ongoing revenue. So, when calculating your ARR, make sure that you exclude any one-time charges or fees.
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Differences between ARR and MRR
ARR is calculated annually, while monthly recurring revenue (MRR) is calculated monthly. MRR provides a more granular financial picture, showing changes on a month-to-month basis. For example, if you have a change in pricing strategy in April, you can measure the immediate effect in May. MRR also lets you track revenue fluctuations based on things outside your control, like shopping seasons or economic conditions.
Why is ARR important to track?
ARR provides a clear picture of a company's expected revenue for the next year, allowing for better financial planning and forecasting. It also helps track a company's growth over time by comparing ARR year over year (YOY). ARR provides a consistent and predictable revenue stream, helping businesses forecast future income accurately. And companies with stable ARR are often valued more highly by investors because of their predictable cash flow. They're are more attractive because investors prefer stable revenue streams over fluctuating one-time sales.
Some other benefits of ARR include:
- Customer retention: ARR emphasises the importance of maintaining long-term customer relationships, leading to increased customer loyalty.
- Reduced sales pressure: There's less pressure on the sales team to constantly acquire new customers, so they can focus on upselling and cross-selling to existing customers.
- Sales targets: With a consistent revenue stream, it's easier for sales and marketing leaders to set realistic goals for their reps.
- Scalability: It's easier to scale operations and growth strategies with a reliable revenue base.
- Performance metrics: ARR provides clear metrics on revenue growth and customer retention.
- Customer insights: ARR offers valuable insights into customer behaviour and preferences through subscription and usage patterns.
How to use ARR in your financials
Using just ARR to understand your company's financial health is like painting a picture with only one colour. ARR needs to be accompanied by other metrics to show the entire landscape.
To have an accurate valuation for your company, you also need to track:
- Gross margin: The revenue that's left after the cost of goods sold (COG) are subtracted.
- Growth rate: The YOY growth rate of a business reflects its potential to scale quickly.
- Net renewal rate: Also known as net revenue retention, this number represents how revenue would change if no additional sales were made.
Once you have ARR, growth rate, net revenue retention and gross margin, you can estimate a company's valuation by using the formula created by tech entrepreneur David Cummings :
10 x ARR x growth rate x net revenue retention = valuation
Here's an example of the formula in practice. An SaaS company with $5 million in annual recurring revenue has a 50% growth rate and 105% net renewal rate. The formula for its valuation looks like this:
10 x $5,000,000 x 0.5 x 1.05 = $26,250,000
You can see how crucial ARR is to finding an accurate valuation of your company.
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How to improve your ARR
Improving your ARR requires four main steps:
- Reduce churn: With an annual subscription, customers are locked in for 12 months. To reduce churn, you need to find out why your customers didn't renew. If your product or service does not meet customer expectations — or worse, just doesn't work — that's the first area for improvements. Personalising the customer experience (CX) also reduces churn. More than half (56%) of consumers say they will become repeat buyers after a tailored experience, according to the latest Salesforce State of Sales Report.
- Market to the right customers: Develop a robust customer profile to help your sales team better understand your target customers' wants, needs and preferences. Get personal with data-driven marketing and deliver the right message to the right audience at the right time.
- Create multiple revenue streams: Offer different platforms, products and upgrades to your customers. But make sure these add-ons are charged annually for them to factor into your ARR.
- Rethink your pricing strategy: Take a look at what your competitors are charging for their products or services. Consider adjusting if you're priced too high in the marketplace — or too low.
What to look for in sales-tracking tools
There are variables that affect how your ARR is calculated — and that's where customer relationship management (CRM) software comes into play. Your CRM is only as good as the data you and your team input.
And with sales tracking — the process of collecting, analysing and reporting on sales data — you will have a clear understanding of your company's performance.
When setting up a sales-tracking system, it's important to create a logical workflow — how you collect data, sift through it and report on it. It's essential to make sure the reports generated are clear and highlight key metrics that provide actionable insights.
In addition to your CRM, here are three other sales-tracking tools that can turbocharge your sales tracking:
- Visualisation and dashboard tools: Sales dashboards can help to visualise sales data in real time, turning rows of data into clear, actionable insights. At a glance, you can see where you're hitting your targets — and where you need to switch gears.
- Real-time analytics tools: The best analytics tools dig deep into your sales data, uncovering trends and patterns that aren't immediately obvious. These tools track conversion rates and pinpoint your most lucrative sales channels.
- Automation tools: Sales reps spend just 28% of their time actually selling, according to Salesforce's State of Sales Report. Automated tools help to capture data such as emails, phone calls and customer interactions — and then automatically log that information directly into your CRM.
Keep ARR in your arsenal
ARR is an essential metric for any business with a subscription model. It represents the predictable revenue expected annually and is vital for assessing a company's financial health and potential for growth. To optimise ARR, companies should focus on reducing churn, targeting the right customers, diversifying revenue streams and refining pricing strategies. With ARR, you have one more tool in your sales playbook.
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