What is Annual Recurring Revenue (ARR)?
Annual recurring revenue (ARR) refers to revenue, normalized on an annual basis, that a company expects to receive from its customers for providing them with products or services. Essentially, annual recurring revenue is a metric of predictable and recurring revenue generated by customers within a year. The measure is primarily used by businesses operating on a subscription-based model.
- Annual recurring revenue (ARR) is normalized on an annual basis revenue that a company expects to receive from its customers for providing them with products or services.
- Annual recurring revenue (ARR) is a metric for quantifying a company’s growth, evaluating its subscription model, and forecasting its revenue.
- Breaking down ARR into individual components (ARR added from new customers, ARR added from upgrades, etc.) enables tracking which customer segments contribute the most to the company’s revenue generation.
ARR vs. MRR
The ARR metric is very similar to monthly recurring revenue (MRR). The only difference between the two metrics is the period of time at which they are normalized (year vs. month). Thus, ARR provides a long-term view of a company’s progress, while MRR is suitable for identifying its short-term evolvement.
ARR is a critical metric for both a company’s management and investors. Managers can use the measure to evaluate the overall health of the business. In addition, ARR can also be utilized to assess the company’s long-term business strategies.
From the investors’ perspective, the predictability and stability of ARR ensure that the metric can be used to compare the company’s performance against its peers, as well as to compare it with its own performance across time.
Uses of ARR
Annual recurring revenue (ARR) is considered one of the most important metrics for subscription-based companies. The metric offers some crucial applications for a company:
1. Quantifies the company’s growth
The predictability and stability of ARR make the metric a good measure of a company’s growth. By comparing ARRs for several years, a company can clearly see whether its business decisions are resulting in any progress.
2. Evaluate the success of the business model
Unlike total revenue, which considers all of a company’s cash inflows, ARR evaluates only the revenue obtained from subscriptions. Thus, ARR enables a company to identify whether its subscription model is successful or not.
3. Forecast revenue
Similar to MRR, ARR is commonly used for revenue forecasting. The metric is commonly referred to as a baseline, and it can be easily incorporated into more complex calculations to project the company’s future revenues.
How to Calculate ARR?
The calculation of ARR considers only recurring revenue and excludes any one-time or variable fees.
In a simplified scenario, annual recurring revenue can be calculated from figures related to multi-year contracts. Consider a company with one customer who took up a five-year subscription for a total amount of $10,000. Determine the company’s ARR by simply dividing the contract’s total amount by the contract’s length:
ARR = $10,000 / 5 = $2,000
For multiple customers, repeat the same calculation for each customer and determine ARR by adding all the yearly amounts.
However, in real life, companies prefer breaking down the total figure into some individual ARRs. The common ARR components include the following:
- ARR added from new customers
- ARR added from renewals from current customers
- ARR added from upgrades from current customers
- ARR lost from downgrades from current customers
- ARR lost from churned customers
Breaking down the total figure helps a company identify which customer segments contribute the most to its ARR.
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