Subscription fees are the main revenue stream of any subscription business, and accurately measuring that revenue plays a crucial role in understanding the financial health of your business and making wise investment decisions. Having a metric that tracks the year-over-year revenue flow allows for long-term planning and a realistic road map for the company’s growth. This is where ARR comes into the picture.
The Annual Recurring Revenue metric gives you an overview of your company’s performance on a yearly basis. It considers the fluctuations in recurring sales, renewals, upgrades, downgrades, and churn to quantify business growth, stability, and profitability.
Without an accurate ARR calculation, you can easily misjudge the financial health and trajectory of your business, and you might end up misleading your teams and potential investors. So let’s take a look at what ARR is, why a subscription business needs to track this metric, and how to calculate it, including detailed examples.
What is Annual Recurring Revenue (ARR)?
Annual Recurring Revenue is an essential metric that predicts how much revenue a company is expected to generate every year from its customers. To be more specific, it is the annualized version of Monthly Recurring Revenue (MRR), where the recurring revenue is normalized for a single calendar year.
The ARR calculation includes gains from subscription charges, recurring revenue from add-ons or upgrades, and losses from downgrades or canceled subscriptions. The calculation also includes the impact of coupons, discounts, and promotional offers provided to the customers. It excludes one-time fees, taxes, credit adjustments, and other non-recurring charges such as training and setup fees.
Why is tracking Annual Recurring Revenue important for SaaS businesses?
Whether you are planning to upgrade your products or increase the pricing, understanding the real-time impact of your decisions on your business is crucial to your growth. Let’s see how ARR helps.
Monitor financial health
A year-over-year analysis using ARR gives you the big picture of your business’s financial health. ARR measures the performance of the business in different areas such as new sales, renewal rate, and upgrades, highlighting where revenue is growing and declining. With these insights, you can move forward on product planning, operational planning, and resource allocation.
ARR predicts the bottom line of the business, so you can cross-reference it against your acquisition targets and pricing strategies to project where your business will be in the future. This provides a way to forecast your future cash flow and chart the business’s growth trajectory in advance. Moreover, with ARR forecast, any negative variation can serve as a red flag to show you where to act.
Since ARR reflects the stability and profitability of a subscription business, potential investors use it to evaluate how powerful your product is. With ARR, you can analyze the business’s performance across the years and against its competitors. Without ARR, it’s easy to misjudge the actual trajectory of the business and give the wrong impression to stakeholders and potential investors.
How to calculate Annual Recurring Revenue (ARR)?
Calculating ARR is simple but depends on your billing cycle.
ARR Formula for Yearly Billing
If you bill customers on a yearly basis, your ARR can be calculated by dividing the contract value of the subscription by the length of the contract in years.
For instance, if a subscriber signs up for a six-year subscription for $18,000, the ARR would be $3,000 for each calendar year.
$18,000 / 6 = $3,000
ARR Formula for Monthly Billing
If customers are billed monthly, then the ARR can be calculated by dividing the contract value of the subscription by the length of the contract in months. ARR can also be calculated using the MRR (which is the revenue generated per month) with the following formula.
For instance, if a customer subscribes to a product for $300 per month, the ARR would be $3,00 * 12 = $3600
Factoring in fluctuations
During volatile sales cycles and seasons, a business’s lifetime value and churn rate will fluctuate, which in turn impacts its ARR. Factors like add-on purchases, subscription upgrades, downgrades, and cancellations also affect the ARR calculations. So taking these values into account, the complete ARR formula will be:
Let’s understand this formula with an example.
Assume you start off this month with $100k in monthly recurring revenue or $1.2 million in ARR. Here’s how you will calculate MRR next month:
MRR at the start of the month: $100,000
MRR lost to subscription cancellations: -$5,000
MRR lost to subscription downgrades: -$1,000
Expansion MRR from upsells: $8,000
MRR gained from new signups: $10,000
With all these figures, you can calculate your total new MRR to be $100,000 – $5,000 -$1,000 + $8,000 + $ 10,000 = $112,000
Or to get your ARR: $112,000 * 12 = $134,4000
Factors to consider in ARR calculation
Although calculating ARR is pretty straightforward with the formulas above, there are a few things to keep in mind to avoid :
When you provide discounts, don’t include the full price of the subscription in the ARR calculation, because the customers are only going to pay the discounted price. For instance, if you offer a $1,000 yearly subscription with a special discount of 50% in the first year, calculate your ARR using a subscription value of $500 per year, not $1,000. Once the customer starts paying the full price, the actual subscription charge can be used in the calculation.
Although most SaaS businesses offer a free trial period, some subscription businesses offer a paid trial instead. This typically carries a small fee compared to the regular subscription cost, allowing customers to ease into the idea of paying for the service before subscribing to an actual plan.
For instance, imagine you run a gym, an acclaimed fitness membership platform that offers Silver ($50), Gold ($100), and Platinum ($200) programs. You offer a 30-day paid trial for $30 to the prospects to check which setup will be convenient to them.
This trial amount is not recurring revenue but a one-off fee, so if you include it in your ARR calculations, you will see a minor increase in ARR but higher churn later. Instead, include their full subscription charges in your ARR calculation only after the prospect gets converted to a paying customer.
Include late payments not delinquent charges
Payments often get delayed due to several factors and understanding how late payments impact the KPIs play a crucial role in your company’s forecasting ability. Technically in an end-of-the-year or month calculation, failed payments are just gone and should not be incorporated in the total revenue calculation but some companies include the uncollected payments into ARR calculation since they go by the notion that they have earned the revenue so it is right to include them. However, that is a wrong practice and might give a misleading result. Make it a practice to group the late payments and track them to understand how much money you lose due to payment declines or failures. Only after the delinquent customer makes the payment, add it to the ARR calculation of the respective period. For instance, say one of your customers didn’t pay the subscription fee of $100 for the March month on the agreed billing date. In that case, you shouldn’t add the uncollected amount to your March month revenue calculation, and if that customer pays that $100 the next month, April, only then add it to the recurring revenue collection of March.
On other hand, some businesses collect late payment fees. Such charges shouldn’t be included in the recurring revenue calculation as those are a one-off thing.
Annual recurring revenue is a key SaaS metric that offers insights into your business’s overall health. Since ARR isn’t a static metric, it shows how your decisions have impacted the business’s performance over the years. By tracking revenue fluctuations with the help of ARR, you can strategize product development and refine sales and marketing plans as you move forward. Overall, ARR is a good indicator of your business’s ability to grow, and it makes it much simpler to gauge the company’s continued success and stay one step ahead.
Zoho Billing, an end-to-end billing management solution with enhanced reporting capabilities, tracks metrics like ARR to help you make insightful budget evaluations and forecast revenue. Take Zoho Billing for a test drive to see how it can make it easier for you to run your business.