How can you gauge your business's growth at the end of the year? And how can you forecast your annual revenue accurately? To navigate your business's taxes effectively, you'll need to consider several financial metrics, or key performance indicators (KPIs). Below, we'll help you learn what you need to know about annual recurring revenue (ARR): what it means, how to calculate it, how it works, and more.
What's in this article?
- What is ARR?
- Which businesses does ARR apply to?
- What's the purpose of ARR in finance?
- How is ARR calculated?
- What are the limits of ARR?
- What are the benefits of ARR?
- How can ARR tracking be optimised?
What is ARR?
Annual recurring revenue (ARR) is a metric that allows businesses to predict revenue flows within a year. The metric is primarily intended to give annual revenue a degree of predictability.
It's important to note that ARR alone cannot capture a business's fiscal health, and that other data is necessary for a comprehensive appraisal.
Which businesses does ARR apply to?
ARR is particularly useful for businesses with recurring revenue that operate on a subscription-based model – a common practice in the software-as-a-service (SaaS) sector. The calculation of ARR is contingent on two criteria: a minimum 12-month subscriber commitment and the exclusion of non-recurring revenue.
What's the purpose of ARR in finance?
ARR provides a general overview of a company's finances, but it is not a precise measure. That said, most businesses use ARR for quantifying changes to recurring income, gauging expenses for financial planning purposes and forecasting revenue for upcoming years.
How is ARR calculated?
ARR is calculated from two variables: the number of subscribers within a year multiplied by the annual subscription price.
ARR = annual subscriptions x annual subscription price
Businesses that sell short-term commitments are advised to use the monthly recurring revenue (MRR) calculation. The only difference between ARR and MRR is the period of revenue analysis (year vs month).
Going from MRR to ARR is hassle-free; you simply need to multiply the monthly revenue by the 12 months of the year:
ARR = MRR x 12
What are the limits of ARR?
ARR calculation has its limits. It can't account for churned customers, upgrades and downgrades from current subscribers, discounted subscriptions, subscriptions running for more than a year, additional and non-recurring subscription fees, as well as customer acquisition costs. You'll need to turn to other performance metrics to calculate your exact annual revenue.
What are the benefits of ARR?
ARR is an amount that a business strives to achieve, or even exceed. This metric helps a business determine its targets for the year (and beyond) and quantify its expenses and costs when making fiscal and strategic decisions. If the ARR is neither exceeded nor achieved by the end of the year, the business analyses its financial situation.
ARR also plays a key role in presentations to investors and bank lenders (you can find out more about ARR-based lending in our article on this topic). From their perspective, ARR reflects the financial health of the business while also providing indicators of customer base growth, business model reliability and the promise of return on investment, if any. While bank lenders rely on ARR to determine the loan value for financing requests, investors use it to evaluate the business itself. In short, ARR is a reference point in acquisition and consolidation discussions.
How can ARR tracking be optimised?
State-of-the-art billing software such as Stripe Billing lets you track and manage your product's revenue and subscription streams. Stripe provides you with an automated, interactive Dashboard, which allows you to analyse and filter all your data to calculate your recurring revenue each month. Find out how you can automate the calculation of your performance indicators with Stripe by contacting one of our experts.