What is Annual Recurring Revenue (ARR) and How to Calculate It
There are several metrics to measure in sales, but none mirrors revenue, customer acquisition and retention like ARR. It also summarizes a company’s growth and serves as a key valuation parameter for investors seeking to measure a company’s financial health, stability, growth and profitability. And for that reason, a slight mistake in your evaluation could present a wrong valuation of your business to potential investors.
On the surface, calculating ARR sound easy, but some people slip in items that should be exempted during its calculation, and end up presenting a figure that represents their revenue instead.
This guide helps you avoid such costly mistake by shedding more light on how to accurately calculate and improve your ARR, plus how it differs from total revenue.
What is ARR?
Annual recurring revenue or ARR for short is a key metric that shows the amount of recurring revenue a company generates yearly. The metric is utilized dominantly by subscription-based companies with a multi-year or monthly recurring contracts. As you can see, you can’t talk about ARR without putting monthly recurring revenue (MRR) into account since ARR is x12 of MRR.
Keep in mind that ARR is the metric investors evaluate to measure the growth of a company and also forecast revenue. MRR is more useful in-house to evaluate day-to-day activities. An increment in MRR each month means a company is on course to hitting its revenue target, while less demands more effort and better strategy from the sales team.
One trend noticed in businesses who use ARR is that subscriptions might be paid monthly, quarterly, or annually and are computed together at the end of the business year. But then, it’s important to exempt one-time fees such as add-ons, upgrades, coaching programs, or course sales when evaluating ARR.
How do I Calculate ARR?
On paper, calculating ARR sounds very basic. But reality, it gets tricky when you don’t know what to include or exclude. Include the wrong items, and you will end up with a false valuation of your business, which could be misjudged as lying to investors.
The key to the right valuation is to only consider the recurring aspect of your subscription model. This mean subtracting discounts, one-time offers, non-repeated add-ons, and additional earnings from course sales and coaching (those items should form part of yout total revenue).
As you can see, the key to an accurate valuation is not letting non-recurring assets slip in. Do so, and you’ve taken care of the hard part. Now to the easy part – What’s the formula for calculating ARR?
It’s simply your MRR x 12
To put that into practice, let’s assume your SaaS business generates $100,000 MRR, multiplying that over 12 months, you end up with $1.2M in ARR.
How Is ARR Different From Revenue?
The simple answer is: Revenue takes into account the total cash flow into a business while ARR calculates recurring subscriptions and payments. For SaaS businesses, a large chunk of revenue can come from recurring income. But when calculating total revenue, companies have to take into account add-ons, upgrades, discount offers, and all other items excluded from ARR valuation.
Hence, there’s a tiny line between both. And when you include items that should be exempted, what you’re presenting to investors is total revenue and not ARR.
How Do I Improve ARR?
It’s good to meet your revenue goal but if you’ve recorded the same ARR for 5 consecutive years, it’s an indication that sales are stagnating. Here are quick tips to help you optimize your recurring income while retaining your best customers.
Expand Customer Acquisition Effort
The first recommendation is to acquire more customers. To achieve this, you can create more personas in your business if your product was previously limited to a small percentage of your market. You could also improve awareness with content marketing, influencer outreach or social media promotion.
Offer Value Upfront
Software users prefer to experience the value of a product before paying for it. Unfortunately, some businesses fail to offer free tier plan to new prospects. Doing so ensure they get to try your product for no financial risk and are likely to become paid users.
Increase Retention Rate
Retention pays more dividends than acquisition if you ask me. You can spend $50 to acquire new customers and $0 to get existing customers to extend their contract. Rather than chasing after new prospects, focus equal attention on maintaining long term relationship with existing customers.
Don’t Be Scared of Upsells
Promote additional features on services towards existing customers. However, this only makes sense if the upsell is equally valuable and offers something different to the main product.
You shouldn’t be pushy with your upsell to Ava our sounding salesy.
ARR is a compound effort from several revenue generating activities. But one of the effort that stands out is the ability to close deals especially since virtual selling seems like the new norm.