What Is ARR? Why It’s A Major KPI For Subscription Companies

ARR, an abbreviation of the term Annual Recurring Revenue, is a key metric used by subscription-based companies, particularly those in the SaaS industry, to measure their recurring revenue over a 12-month period.

In this post I’ll go over how to calculate Annual Recurring Revenue, how it may differ from a company’s total revenue, how to get to ARR from MRR, ARR vs. GAAP revenue, and why it’s such a key metric for subscription businesses.

What is ARR?

ARR, or Annual Recurring Revenue, is revenue generated from subscription contracts that renew on a yearly basis (or less frequently, in the case of multi-year contracts).

What’s the difference between ARR and MRR?

Many younger SaaS and subscription businesses don’t contract customers into yearly subscriptions – especially when selling directly to consumers (D2C). These subscription businesses typically drive recurring revenue with monthly subscriptions.

This means that they’re generating recurring revenue on a monthly, rather than annual recurring basis, and typically use Monthly Recurring Revenue (MRR), rather than Annual Recurring Revenue, as a more appropriate metric for managing day-to-day operations.

How to calculate Annual Recurring Revenue (ARR)

Because MRR is often used as the key recurring revenue metric for running monthly subscription-based businesses, in order to understand a picture of the company’s annual repeating revenue, many executives, analysts and investors include all recurring revenue in the Annual Recurring Revenue calculation, whether it is annual or monthly recurring.

While many people will still refer to this calculation as calculated annual recurring revenue, it may also be described as ‘annual run rate’.

However, what truly matters is whether the calculation is appropriate for understanding the company’s recurring revenue when looking at it on a 12-months basis, and that the company’s management and external parties using the information understand how the figure was arrived at.

For the majority of businesses that have these revenue models, the prevailing method of calculating ARR that I use and see used is therefore to take the company’s MRR and multiply it by 12.

Annual Recurring Revenue vs. Total Revenue

ARR only takes into account your subscription-based revenue, whereas the total revenue of your business includes all revenue streams, recurring or otherwise.

Other revenue not included in your company’s ARR may be made up professional services, and include one time sales such as implementation fees, hardware revenue, one-off pilot fees and perpetual software license fees.

What about ‘reoccuring’ revenue?

Reoccuring revenue is revenue generated from repeat customers that (unlike a regular monthly software subscription of $x per month, every month) is not necessarily tied to a predictably repeating timeline, nor for necessarily the same amount each month.

Examples of reoccurring revenue include repeating revenue that fluctuates month to month based on transaction volumes, or the portion of revenue that repeats but does so with variable pricing or on an infrequent or inconsistent cycle.

Either way, it’s not considered predictable revenue in the same way as consistent and fixed monthly subscription business revenue is but it’s still very important to understand the quantum and behavior of this revenue, and be able to demonstrate its value to a potential buyer or investor in the context of a potential sale of the business.

As it would be potentially misleading to simply combine your reoccurring revenue streams with revenue from your subscription business to calculate ARR, I generally bifurcate recurring and reoccurring revenue so they can be understood separately. If you love charts then a stacked column chart is a good way of presenting this.

ARR vs GAAP revenue

GAAP revenue is backward-looking, whereas ARR takes your annual recurring revenue at a point in time – as of the last month, if you calculate ARR as the last month’s MRR x 12.

So, if your subscription business is in a growth phase, then ARR and GAAP revenue recognition for the last 12 months are inevitably going to be different – you’d expect ARR to be significantly higher than the last 12 months’ GAAP revenue.

Conversely, if you have attrition in your subscription business then the ARR you calculate is likely to be lower than GAAP revenue for that part of your business.

Additionally, remember that a company’s total GAAP revenue will include all revenue streams, so if there are more than simply subscription revenues being reported, this will also be a reason for the difference between ARR and GAAP revenue you may see.

Why is Annual Recurring Revenue important?

ARR is important for a number of reasons, with some of the most significant being:

  • It is a measure of predictable revenue and therefore forms a key basis for ongoing revenue and cash flow forecasting
  • It is a key element in understanding a company’s current performance
  • It is commonly used as a basis for assessing a company’s valuation.

However it’s worth considering that in order to more deeply understand this aspect of a company’s performance and future revenue growth trajectory, you need to understand how recurring revenue has been trending over time, as well as delving deeper into the components that make up ARR, including:

  • how much is from new customers, existing customers renewing and upsells (expansion revenue) – together drivers of ARR growth, offset by
  • downsells (contraction) and churn (revenue lost) – drivers of ARR reduction.

So, while understanding and calculating Annual Recurring Revenue is essential for SaaS companies and businesses with subscription models, it’s important to remember that it’s just one of a suite of key financial metrics that are vital to track.

Other metrics, such as Annual Contract Value (ACV), Bookings, Churn Rate and Customer Acquisition Cost (CAC) provide other valuable insights into a company’s financial health and growth potential.

  • ACV is a measure of the average annual revenue generated by each customer contract, and it can help businesses to determine the lifetime value of their customers.
  • Bookings refers to the total value of customer orders that have been placed and represents the amount of contractually obligated revenue that a company expects to recognize in the future.
  • Churn rate measures the rate at which customers are canceling their subscriptions, and it can be used, among other things, to identify areas of a business that need improvement.
  • Customer Acquisition Cost (CAC) is the total cost incurred by a business to acquire a new customer, and is important to track to understand the cost-effectiveness of marketing and sales efforts and make informed decisions about resource allocation.

By tracking a comprehensive set of financial KPIs, businesses can gain a more comprehensive understanding of their financial performance and make more informed decisions about pricing, future growth strategies, and resource allocation.

Helen Dixon is a fractional CFO and strategic financial consultant for dynamic growth companies in the San Francisco Bay Area and works remotely with clients across the US and internationally.

© 2023 Helen Dixon: Growth-Focused Fractional CFO & Financial Consultant. All Rights Reserved.