What is Annual Recurring Revenue (ARR)?

Does your business charge clients regularly (like every month or year)? If so, it's helpful to know about Annual Recurring Revenue (ARR). This represents the total amount of money your company expects to get from its customers over an entire year. It helps you predict how much money you'll make, plan for the future, and see how well you're doing overall.

Monthly Recurring Revenue (MRR) is similar. As the name suggests, it's the amount of money your company expects to get in just one month. While MRR is helpful for short-term planning, ARR gives a bigger picture of how your company is doing and how much it might grow.

For subscription-based business models, ARR shows how valuable your customer relationships are and whether your business model is working well.

How to Calculate Annual Recurring Revenue

Before you crunch the numbers, consider the following factors that affect ARR:

• Monthly Recurring Revenue: This is the total predictable revenue generated from active subscriptions in a given month.
• Subscription Term: This is the length of the subscription commitment (monthly, quarterly, annually, etc.).
• Upgrades/Downgrades: Any changes to the subscription plans that affect the recurring revenue.

Here's the ARR formula:

1. Calculate the MRR by multiplying the number of active subscriptions by the average revenue per subscription. MRR = Number of Active Subscriptions × Average Revenue per Subscription
2. Normalize the MRR to reflect the annual value based on the subscription term.
   • For monthly subscriptions, multiply the MRR by 12.
   • For quarterly subscriptions, multiply the MRR by 4.
   • For annual subscriptions, the MRR is already the ARR value.
3. Adjust the ARR for any upgrades or downgrades that occurred during the period. ARR = Normalized MRR ± Upgrades/Downgrades

For example, if a company has 100 monthly subscriptions at $50 per month and 20 annual subscriptions at $500 per year, the ARR calculation would be:

Monthly Subscriptions ARR = 100 × $50 × 12 = $60,000 Annual Subscriptions ARR = 20 × $500 = $10,000 Total ARR = $60,000 + $10,000 = $70,000

Why You Shouldn't Include One-Time Payments

One-time fees are generally excluded from the annual calculation, and there are a few compelling reasons why:

• Predictability: One-time fees, by definition, aren't predictable. Including them in the annual calculation would introduce volatility and make it harder for you to accurately forecast future revenue.
• Business health: Recurring revenue indicates a loyal customer base and a sustainable business model. While valuable, one-time fees don't contribute to the long-term stability of the business in the same way as recurring revenue.
• Investor perspective: Investors and analysts are primarily interested in the recurring revenue stream, as it provides a more accurate picture of the company's future performance. One-time fees can skew the calculation, giving a misleading impression of the company's growth trajectory.
• Industry standards: Excluding one-time fees from ARR is a common practice in the subscription-based business world. Following this standard allows for better comparability between companies and aligns with investor expectations.

This doesn't mean that one-time fees aren't important. Just track and report them separately, as they significantly contribute to your company's overall revenue and cash flow. 

Components

New 

New ARR represents the annual recurring revenue generated from new customers acquired during a specific period. For example, if you sign up 10 new customers in a month, each paying $100 per month, your New ARR for that month would be $12,000 (10 × $100 × 12).

Expansion 

Expansion ARR is the additional recurring revenue generated from existing customers who upgrade their subscriptions or purchase additional services. For instance, if an existing customer paying $100 per month upgrades to a $150 per month plan, the Expansion ARR would be $600 ($50 × 12).

Reactivation 

Reactivation AR is the recurring revenue regained from customers who had previously canceled or downgraded their subscriptions but have reactivated their accounts. If a customer who used to pay $100 per month cancels and later reactivates their subscription at the same rate, the Reactivation ARR would be $1,200 ($100 × 12).

Contraction 

Contraction AR refers to the loss of recurring revenue due to customers downgrading their subscriptions or reducing the number of seats or usage. If a customer paying $200 per month downgrades to a $150 per month plan, the Contraction ARR would be -$600 (-$50 × 12).

Churned 

Churned AR is the loss of recurring revenue from customer churn—customers canceling their subscriptions entirely. If a customer paying $100 per month cancels, the Churned ARR would be -$1,200 (-$100 × 12).

Net 

Net ARR is the net change in ARR over a given period, considering all the components mentioned above. It's calculated as follows: Net ARR = New ARR + Expansion ARR + Reactivation ARR - Contraction ARR - Churned ARR Net ARR provides an overall picture of the company's ARR growth or decline during a specific period.

Here's a simple example to illustrate these components:

• At the start of the month, your company has an ARR of $100,000.
• During the month, you acquire five new customers, each paying $100 per month (New ARR = $6,000).
• Two existing customers upgrade their plans from $100 to $150 per month (Expansion ARR = $1,200).
• One canceled customer reactivates their subscription at $100 per month (Reactivation ARR = $1,200).
• One customer downgrades from $200 to $150 per month (Contraction ARR = -$600).
• Two customers cancel their subscriptions at $100 per month each (Churned ARR = -$2,400).

The Net ARR for this month would be $5,400 ($6,000 + $1,200 + $1,200 - $600 - $2,400).

Comparisons to Other Financial Metrics

Monthly Recurring Revenue

• ARR and MRR differ in their time scale.
• MRR represents the predictable revenue a company expects to receive on a monthly basis from its recurring subscriptions.
• ARR is simply the MRR multiplied by 12, representing the annual value of the recurring revenue.
• While ARR provides a longer-term view of the recurring revenue, MRR offers a more granular, month-by-month perspective.

Revenue

• Revenue is the total amount of money a company earns from its business activities, including both recurring and non-recurring sources.
• ARR only focuses on the recurring portion of the revenue, specifically from subscription-based products or services.
• Revenue includes one-time fees, professional services, and other non-recurring income, while ARR excludes these components.

Bookings

• Bookings represent the total value of contracts signed with customers during a specific period, regardless of when the revenue will be recognized.
• ARR, on the other hand, represents the annualized value of the recurring revenue that a company expects to receive from its current subscriptions.
• Bookings can include both recurring and non-recurring elements, while ARR focuses solely on the recurring portion.

Why Annual Recurring Revenue Isn't a GAAP Metric

The Generally Accepted Accounting Principles (GAAP) metric is a set of standardized accounting rules used for financial reporting. Annual recurring revenue isn't a GAAP metric for several reasons:

1. Revenue recognition: GAAP has specific rules for recognizing revenue. Revenue is typically recognized when it is earned and realized or realizable, which often doesn't align with the recurring nature of ARR.
2. Subscription term: ARR assumes that a subscription will continue for a year, but GAAP requires revenue to be recognized over the actual subscription term, which could be monthly, quarterly, or annual.
3. Inclusion of non-recurring elements: ARR strictly focuses on recurring revenue, while GAAP requires the inclusion of all revenue sources, including one-time fees and non-recurring items.
4. Standardization: GAAP provides a standardized framework for financial reporting, ensuring comparability across companies. ARR, while widely used in the subscription business model, lacks the same level of standardization and may be calculated differently by different companies.

Using ARR to Drive Business Decisions

Tracking the annual value of all active subscriptions helps you make informed decisions that drive sustainable growth.

Strategic Planning and Forecasting

Subscription businesses can forecast revenue, evaluate growth strategies, identify upsell opportunities, analyze churn, and plan resources. Your company can make data-driven decisions to optimize growth, minimize churn, and allocate resources effectively. 

Pricing Strategy Adjustments

Annual subscription data can reveal the impact of pricing on customer acquisition, retention, and expansion. If you analyze by pricing tiers, you can see optimal price points that balance your growth and profitability.  

Try experimenting with pricing strategies and measuring ARR changes to maximize revenue and customer lifetime value. And if you regularly review and adjust pricing based on ARR insights, your company will remain competitive and better align with your customers' expectations.

Customer Retention and Expansion

By analyzing ARR churn and expansion rates, you can pinpoint successful strategies and areas your business can improve upon. You'll have a better picture of where to upsell and cross-sell based on ARR data. This helps you expand revenue from your existing customers and drive long-term growth.

Investment and Funding Decisions

Investors look at ARR to evaluate the potential and health of subscription businesses. Higher ARR growth rates and lower churn rates demonstrate a strong business model and market fit. By presenting ARR metrics and growth projections, you can attract investors and secure more funding.

Day-to-Day Efficiency

ARR data can help identify areas for operational improvement and cost optimization. By analyzing ARR per employee, you can gauge their productivity and efficiency. And if you compare ARR growth to customer acquisition costs and customer lifetime value, it'll reveal opportunities for your team to streamline sales and marketing efforts. 

ARR churn rates can highlight areas where operational issues may be impacting customer retention. You can use ARR insights to optimize how you allocate resources, automate processes, and better support customers.

Market Expansion and Product Development

ARR helps you pinpoint key customer segments and regions with high potential. Examining your annual growth rates and the cost of acquiring customers in different markets helps identify expansion opportunities. This information allows you to adjust your pricing and customize your marketing to better suit each market's preferences.

Challenges and Limitations

Clearly, ARR is a useful tool that drives your business forward. Still, it comes with challenges and limitations.

For one, not all of your revenue is going to be recurring, so this metric doesn't give you a complete picture of how much you earn. It doesn't include one-time fees or non-recurring income, so you must track total revenue as well.

You're also assuming constant renewal rates, but the reality is that these can fluctuate. Your customers won't always continue to renew their subscriptions at the same rate. Be sure to analyze your past renewal rates and customer behavior and regularly update your forecasts based on actual renewal data to improve accuracy.

And because you're calculating ARR based on the assumption that contracts will last a full year, segment your ARR by contract length. Break down ARR into groupings based on contract lengths (like monthly, quarterly, and annual).

Track the timing of your customer payments and monitor your cash flow closely because ARR doesn't account for payment timings. It represents the total value of contracts but doesn't consider when you'll get your money. As a result, you might have a high ARR but still face cash flow issues if you have delayed or spread out payments.

Lastly, calculating ARR relies on having accurate and up-to-date data on customer contracts and subscription changes. If data tracking is inconsistent or incomplete, your ARR figures might not be reliable. To solve this, make sure you're working with a reliable billing and revenue management system. Regularly review and reconcile your ARR data to correct any discrepancies, and invest in the right automation tools to make your job easier.

Concluding Thoughts

By implementing these strategies, you can enhance the reliability and usefulness of ARR as a metric. It's a great way to see how your business is doing, and it helps you predict the financial trajectory of your subscription-based company.

Want to see how a robust accounting system helped one organization strengthen customer relationships and financial stability? Check out PINATA's success story with Tabs.