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Annual Recurring Revenue (ARR) represents the total value of a company's recurring revenue generated by subscriptions over the course of a year. Indispensable as an indicator of a company’s financial health and growth trajectory, ARR is relevant for any business that has subscription revenue – Software-as-a-Service (SaaS) companies, gyms, workout studios, magazines, streaming networks, etc.
For the purposes of this article, we’ll be focusing on ARR as it relates to SaaS and cover the following key topics:
- The meaning of ARR
- Why ARR matters for businesses
- How to calculate ARR
- Examples of how businesses use ARR
And more. Let’s get started.
What is ARR in business?
ARR is a key metric for subscription businesses and represents the total value of all customer contracts across a 12-month period. ARR doesn’t just signify a SaaS business’s stability and growth potential, but also its ability to raise capital because investors love the contractually-obligated, predictable and recurring nature of ARR.
Why ARR matters
ARR is in the DNA of the SaaS business model – you can’t have one without it. At a more granular level, ARR helps SaaS businesses understand the efficacy of their subscription model and strategies in the long run. It also gives SaaS businesses clarity around revenue predictability, supports financial forecasting and solidifies investor confidence.
All of this goes a long way in influencing business decisions like:
- Workforce planning
- Marketing and R&D budget
- Sales pricing strategies
- Pipeline management
- Product development
- Growth strategies
- Travel expenditures
- Mergers and acquisitions (M&A)
Pretty much all business expenses are, in one way or another, influenced by ARR and ARR projections.
Still with us? Good, now let’s take a closer look at how ARR supports revenue predictability, financial forecasting and investor confidence.
Revenue predictability
The beauty of ARR is that it offers stable and predictable revenue – which, at the end of the day, is the lifeline of any business.
Unlike one-time sales, where revenue can fluctuate significantly from month to month, ARR is money guaranteed, month over month, year after year, for the length of the contract. Customer churn, of course, has a major impact on ARR, and we’ll cover more on that below.
This stability is essential for forecasting and planning purposes, allowing SaaS businesses to make informed decisions about resource allocation, investments, budgeting and growth strategies – leading to greater stability and resilience in the face of market fluctuations.
But ARR also gives SaaS businesses visibility.
As contracts near their end or subscription renewals approach, companies are better able to identify potential revenue gaps or opportunities for upselling, cross-selling or, in some cases, down-selling (if necessary to appease a customer’s changing needs or to avoid churn).
In this sense, the revenue predictability of ARR helps businesses see around corners – they’re empowered to adapt their subscription strategy to support the longer-term health of their business, and, in doing so, support the developing needs of their customers.
Financial forecasting
ARR also serves as a critical component of financial forecasting for SaaS businesses.
By tracking recurring revenue streams over time, companies can develop more accurate financial models, project future growth and identify areas for optimization. This insight into past and future revenue performance allows for proactive decision-making and alignment with long-term business objectives – it’s also why having an automated advanced billing and revenue management system is so important.
Another advantage of the ‘bird’s eye view’ provided by ARR is that it helps SaaS businesses monitor churn rates and assess the financial implications of churn on recurring revenue.
By understanding the relationship between churn and ARR, businesses can develop effective strategies to reduce customer attrition and increase customer lifetime value (CLV). They can identify how to better support their customers, optimize performance and manage revenue. All of this, in turn, contributes to long-term financial sustainability and customer retention.
Investor confidence
Investors love ARR.
Why?
Because ARR is a key indicator of a SaaS business’s growth potential and market value.
Companies with a healthy ARR that’s growing at a good rate are typically indicative of scalability, high CLV and product-market fit – factors that enhance the company’s valuation and attract potential investors looking for lucrative investment opportunities.
Ultimately, by focusing on growing ARR through optimal revenue management, SaaS businesses can enhance investor confidence, attract additional funding and fuel further expansion and innovation.
How to calculate ARR
ARR looks at projected recurring revenue across 12 months. In simple terms, ARR is equivalent to monthly recurring revenue (MRR) x 12.
The key word here is “recurring”.
For example, for a customer who signed a 5-year contract valued at $500,000, the ARR for that customer would be $100,000. Any one-time fees (e.g., one-time consultation costs) would not be represented in ARR, as they aren’t part of a company’s annualized subscription-based revenue.
That said, arriving at a more accurate ARR calls for companies to consider other metrics like:
- churn rate
- expansion revenue
- net-new ARR
We’re going to dive into the calculations for each of these. But first, we need to know how to calculate MRR.
Calculating MRR
One of the simplest ways to arrive at an accurate projected ARR starts by having a clear picture of MRR (monthly recurring revenue). MRR represents the total revenue generated from recurring subscriptions on a monthly basis – it includes revenue from all active subscriptions within a given month.
In simple words, MRR is the sum of recurring revenue expected to be recorded each month. It's a way of normalizing all the company's subscriptions to the same time dimension - in this case, by month.
While MRR is the optimal metric for assessing short-term subscriptions (less than one year), ARR is valued for examining whether a SaaS business is sustainable longer-term, and it’s typically calculated based on the most current MRR.
How to calculate the monthly recurring revenue (MRR)?
Step 1: List all your subscriptions
Start with a list of all your active subscriptions and look at the subscription amount (total contract value) for each subscription.
Step 2: Calculate the MRR for each subscription
Divide the subscription amount (total contract value) by the duration of the subscription (in months). This will give you the MRR for each individual subscription.
Step 3: Calculate the total MRR
Sum the MRR for each subscription to get the total MRR.
Example:
- Subscription A: $48,000 Contract with a 24-month duration = $2,000 MRR
- Subscription B: $12,000 Contract with a 12-month duration = $1,000 MRR
- Subscription C: $1,500 Contract with a 3-month duration = $500 MRR
Total MRR = $2,000 + $1,000 + $500 = $3,500
Follow this method to accurately and easily calculate your business's MRR and get a clear picture of your recurring revenue stream.
Calculating churn rate
There are two types of churn rates a business typically measures:
- Customer churn rate: the percentage of customers a business loses during a given period of time.
- Revenue churn rate: the percentage of recurring revenue a business loses in a given period of time.
Here’s how to calculate each:
For the purposes of calculating ARR, we’ll be looking at revenue churn rate.
Calculating expansion revenue
Expansion revenue refers to current customers who are growing the value of their contracts via upsells and cross-sells. It can be calculated by dividing the previous monthly revenue of existing customers by their new monthly revenue:
Calculating net-new ARR
Net-new ARR simply looks at the annual value of net-new contracts during a one-year period.
For example, let’s imagine that a SaaS company “X” has an MRR of $10,000/month, or a projected ARR of $120,000. In the most recent month, “X” experienced 5% revenue churn, 3% expansion and acquired $3,000 of new ARR. Calculating a more accurate ARR would proceed as follows:
- At a 5% revenue churn rate, X would be losing $6,000 a year:
ARR ($120,000) × Churn (.05) = $6,000.
Given that this is a loss, ARR churn would be valued at -$6,000.
- At a 3% rate of expansion, X would be gaining $3,600 a year:
ARR ($120,000) × Expansion (.03) = $3,600.
- Finally, X would have $3,000 in net new ARR.
- To incorporate both churn and revenue growth, these values should be added together: Net New ARR ($3,000) + Churn (-$6,000) + Expansion ($3,600) = $600.
- $600 would then be added to $120,000 for a final ARR of $120,600.
By monitoring and optimizing MRR, churn rate, and expansion revenue, subscription businesses can effectively manage their ARR and gauge revenue performance, identify growth opportunities, and make data-driven decisions to optimize their business strategies.
Examples of how businesses use ARR to drive growth and strategy
How have some SaaS businesses leveraged ARR to drive growth and success with subscription business models?
Let’s start with a pioneer of the subscription-based model in the SaaS industry: Salesforce.
Salesforce offered its CRM platform on a subscription basis and, by focusing on ARR, Salesforce shifted from traditional one-time sales to recurring revenue streams, ensuring a more predictable and stable revenue source. This transition allowed Salesforce to establish long-term relationships with customers and generate continuous revenue streams, contributing to its sustained success.
Similarly, Zoom, the video conferencing platform, experienced exponential growth in its ARR following the global shift to remote work in 2020. By offering a user-friendly interface, reliable service, and competitive pricing, Zoom attracted millions of new subscribers and significantly increased its ARR within a short period. This rapid growth not only solidified Zoom's position as a market leader but also demonstrated the power of ARR in driving business success with a subscription model.
As demonstrated by both Zoom and Salesforce, focusing on ARR encourages businesses to invest in their customers. From product improvements and savvy pricing approaches to enhanced service offerings, SaaS businesses' ability to retain happy, loyal customers is the foundation of their recurring revenue growth.
All of this is made much easier with a solution like ZoneBilling, which provides finance teams with a single record to manage the entire customer lifecycle – from initial purchase to renewals – within their cloud ERP. This helps companies seamlessly manage subscription billing and revenue recognition, two critical components in managing, increasing and forecasting ARR.
ARR: critical for the success of any SaaS business
Year after year, ARR gives SaaS businesses certainty and confidence in the decisions they make. The directions they go in. The things they do and don’t do. And, while it may no longer be the key metric in SaaS (like it was during the growth-at-all-costs era of the 2010s), it remains critical within the ever-changing landscape of software and technology.
And that won’t change anytime soon.
Because ARR simply provides too much value to SaaS companies – and it always will.
If you need a solution to help you navigate the complexities of a subscription business model and ARR, streamline billing and revenue recognition, and drive growth, explore how ZoneBilling can help you do all of that and more within your cloud ERP.
FAQs about ARR
Why is ARR important for a subscription business?
By effectively forecasting revenue long-term, ARR provides a way for subscription businesses to monitor their organization’s health, identify opportunities for growth and create strategic improvements in their business model. ARR creates transparency around revenue predictability and, in doing so, establishes investor confidence.
What is the difference between ARR and MRR?
ARR (Annual Recurring Revenue) represents total recurring revenue from subscriptions over a year, offering an annual – and longer-term – view of revenue performance. MRR (Monthly Recurring Revenue) represents total recurring revenue over a month, providing a monthly snapshot of revenue performance for SaaS businesses.
What are the benefits of a recurring revenue model?
A recurring revenue model ensures predictable income streams, fosters long-term customer relationships, supports scalable growth, encourages ongoing innovation, reduces customer churn and enhances business valuation, ultimately driving sustained profitability and competitiveness in the dynamic SaaS market.
Why is recurring revenue important in SaaS?
In the subscription-driven SaaS industry, recurring revenue ensures sustained profitability and a competitive edge. It provides stability through predictable income, fosters opportunities to focus on customer loyalty and retention, drives continuous innovation and, in turn, boosts investor confidence. Ultimately, recurring revenue promotes sustained profitability for SaaS companies.
How is ARR calculated?
ARR = Monthly Recurring Revenue (MRR) x 12
How is MRR calculated?
MRR is the sum of recurring revenue expected to be recorded each month. To calculate MRR, start with a list of all your active subscriptions and look at the subscription amount (total contract value) for each subscription.
Divide the subscription amount (total contract value) by the duration of the subscription (in months). This will give you the MRR for each individual subscription.
Then, sum the MRR for each subscription to get the total MRR.
How is customer churn rate calculated?
Customer Churn Rate (%) = (Number of Customers Lost in a Period / Number of Customers at the Start of a Period)
How is revenue churn rate calculated?
Revenue Churn Rate (%) = (Revenue Lost in a Period / Revenue at the Start of a Period)
How is expansion revenue rate calculated?
Expansion Revenue Rate (%) = (Current Period Revenue from Existing Customers – Previous Period Revenue from Existing Customers / Previous Period Revenue from Existing Customers)
