Annual Recurring Revenue (ARR) is a metric used by companies with subscription-based service models to measure the predictable and recurring revenue generated by customers within a year. This includes revenues from subscriptions, but it may also encompass maintenance and support if they are tied to a subscription agreement.
Here’s a more detailed look at ARR:
ARR is calculated by annualizing the value of recurring revenue from customers. For instance, if all customers are on monthly subscription plans, you would multiply the Monthly Recurring Revenue (MRR) by 12 to get the ARR.
If a customer has a contract that does not bill monthly, the revenue from that contract would be divided by its term in months and then multiplied by 12 to get the annualized figure.
Why ARR is Important:
- Consistency: ARR provides a clear and consistent metric to track revenue that is relatively stable and predictable over the year.
- Company Valuation: For SaaS businesses and other companies with subscription models, ARR is a key metric for investors and is often used in company valuations.
- Performance Tracking: It allows businesses to track and compare year-over-year performance, smoothing out fluctuations that might occur due to seasonality or one-off purchases.
- Business Planning: It helps in planning and budgeting by providing a solid revenue baseline.
- Investment and Funding: Investors typically prefer businesses with high ARR because it suggests a stable future cash flow, which can be indicative of lower investment risk.
Considerations in ARR:
While ARR is a valuable indicator of financial health for a SaaS company, it’s important to consider that:
- ARR only accounts for recurring revenue; it doesn’t include one-time charges, variable fees based on usage, or non-recurring service fees.
- Businesses need to account for churn (lost ARR from customers who cancel or do not renew) as it directly reduces the ARR.
- Growth in ARR is derived from both acquiring new customers and expanding revenue from existing customers through upselling or cross-selling additional features or services.
Expansion in ARR:
ARR can also be used to understand revenue expansion:
- Net ARR: Takes into consideration the revenue gained from new sales and expansion less the revenue lost from cancellations and contractions over a year.
- Gross ARR: Reflects total annual recurring revenue before accounting for any revenue lost due to churn.
Maintaining and growing ARR is typically a primary goal for SaaS companies, as it is a strong indicator of long-term business viability and success.