Summary: ARR measures predictable, recurring revenue from customer subscriptions annually, crucial for assessing financial health and growth potential.
- Benefits of Tracking ARR:
- Future Earnings Forecast: Provides clear forecasts aiding budgeting and investment planning.
- Investor Attraction: Indicates a stable revenue stream, making companies more appealing to investors.
- Customer Retention Insights: Helps track retention and churn, indicating business health.
- Valuation Metric: Critical for evaluating company worth during fundraising.
- Calculation of ARR: Sum up all annualized recurring revenues and adjust for upgrades, downgrades, and cancellations.
There’s no shortage of metrics to help measure business success. However, annual recurring revenue (ARR) stands out as one of the more important ones, especially for companies with subscription-based models.
ARR provides a clear picture of predictable and recurring revenue streams, which are key indicators of financial health and long-term viability. Read on to learn more about how to calculate annual recurring revenue and the importance of this metric.
What is Annual Recurring Revenue?
The Corporate Finance Institute explains that ARR is essentially a metric of predictable and recurring revenue generated by customers within a year.
In other words, ARR only counts revenue that is regular and expected to continue annually. This makes it an essential metric for assessing the stability and growth of businesses that generate revenue from subscriptions. For instance, a Software-as-a-Service (SaaS) company or entertainment businesses that offer yearly subscriptions would benefit from using ARR.
Annual recurring revenue provides many valuable insights for businesses, such as:
- Future Earnings: ARR offers a clear and predictable forecast of future earnings. This is essential for everything from budgeting to investment planning.
- Customer Retention: Tracking ARR can help businesses understand customer retention trends. A rising ARR indicates good existing customer retention and possibly new acquisitions. Conversely, a declining ARR might suggest customer churn.
- Valuation Metrics: For companies, especially startups looking to raise capital, ARR can be a critical metric in valuations. It helps stakeholders understand the business’s growth trajectory and potential future income.
Annual Recurring Revenue vs Revenue
Remember, while general revenue includes every dollar coming into a business, ARR specifically measures the predictable and recurring revenue from existing subscriptions. It does not take into account one-time fees, variable sales, or non-recurring service charges.
One-time transactions can be unpredictable. Meanwhile, ARR highlights the stable, ongoing revenue that can be expected year over year. This makes ARR a true reflection of a company’s earning potential and customer loyalty over time.
What About Monthly Recurring Revenue?
Monthly recurring revenue (MRR) provides a more granular look at revenue growth from month to month. ARR and MRR are closely related, but the latter can help measure the effects of any changes to your strategy or identify trends in revenue fluctuations.
How to Calculate Annual Recurring Revenue
Calculating ARR is fairly straightforward. The experts at Salesforce provide this simple annual recurring revenue formula:
Annual subscriptions + additional ongoing revenue – cancellations = ARR
Follow these steps to help fill in the formula for your business:
- Identify Recurring Revenue Sources: Start by identifying all the sources of recurring revenue. This includes all annual subscriptions or contracts that guarantee revenue on a periodic basis (usually monthly or yearly).
- Calculate Annual Subscriptions: Annualize the Revenue For each recurring revenue source, calculate the annual contribution. If the revenue is charged on a monthly basis, multiply it by 12 to get the annual rate. Do not include any one-time charges or fees.
- Add Ongoing Revenue: Include any additional recurring revenue from your subscription model, like maintenance or support fees.
- Adjust for Upgrades, Downgrades, and Cancellations: It’s important to adjust this figure for the customer churn that occurs throughout the year.
How to Use Annual Recurring Revenue
Knowing how to calculate annual recurring revenue comes in handy for more than just measuring financial health. Businesses can also use this metric as leverage when raising capital.
Here are some ways you can use ARR to help attract investors and secure business funding:
- Demonstrating Financial Stability and Growth Potential: Investors are interested in the profitability and growth potential of a business. ARR provides a clear indicator of both, offering a predictable and stable revenue stream that can be expected to continue year after year.
- Valuing Your Company: ARR is often used to value companies, especially SaaS businesses.
- Negotiating Better Terms: With a significant ARR, you have the leverage to negotiate better terms with investors. This is because a higher ARR is a green flag for investors who want to reduce their risk.
- Showcasing Customer Loyalty and Market Demand: A strong ARR is indicative of a loyal customer base and consistent market demand. Both of these are attractive to investors.
- Planning and Forecasting ARR provides a basis for projecting future revenues and can help you outline how new capital will help accelerate growth.
Looking for more ways to raise capital for your growing business? Learn more about how revenue-based funding from Founders First Capital Partners can provide the non-dilutive capital and advisory services needed to scale your business.
