Annual recurring revenue: what it is and how it’s calculated

ARR (annual recurring revenue) is one of the key SaaS KPIs. It’s an indicator that gives an overall view of expected revenue over the next year and trends over time. ARR is also useful for comparing two SaaS companies (or any company with a subscription-based business model) and communicating with investors.In this article, we’ll look at exactly what annual recurring revenue is and how we measure it. We’ll also explain why this KPI is important and how you can improve it.

What is ARR?

ARR is an indicator that measures recurring revenue over a year, based on the number of subscriptions taken out.

💡 ARR = annual recurring revenue.

It is widely used by companies with a subscription-based business model.It is therefore essential for SaaS business reporting.

This is a very good business indicator, as it can be used to forecast subscriptions (and therefore revenue) over the next twelve months. It also serves as a target for management to aim at (ARR target for the current year or the following year).

How does a SaaS calculate ARR?

ARR is the annualization of MRR (monthly recurring revenues).

Say a SaaS company has an MRR of €36,000. (All recurring revenues, even those for subscriptions that run over several months, must be calculated in monthly terms). Its ARR is, therefore, €36,000 x 12 months:€432,000.

💡 To make a more exact calculation, ARR calculation may also:

• include or exclude discounts;
• include churn rate on the churn date (even if this occurs before the end of the service period) or on the subscription end date.

Why is ARR an important KPI for a SaaS?

When a SaaS company obtains the vast majority of its revenue from subscriptions, ARR is an indispensable KPI. You can use it to:

• forecast recurring revenues;
• compare your company with other SaaS companies (benchmarking);
• calculate the value of your SaaS (valuation often involves a multiple of ARR).

As recurring revenues are contractual revenues, the company can easily forecast its future revenues (all the more so if your team has a significant track record and a good handle on other essential KPIs,such as churn, LTV, and MRR growth rate). ARR is therefore a key KPI for forecasting future annual customer subscriptions when drawing up a business plan.

ARR is also widely communicated with investors. It’s usually the first indicator they look at to understand the company’s size, maturity, and volume of business. In particular,it helps them assess whether the company’s size fits into their investment specifications. 💡 According to US investment fund Point 9, an ARR of between $0.5m and $2.5m generally equates to a Series A, while an ARR of between $3m and $5m equates to a Series B.

ARR or MRR: which KPI to choose?

To steer the performance of a SaaS company, managers regularly monitor a handful of KPIs (thanks to reporting). But should they focus on MRR or ARR?

Since ARR measures the company’s recurring revenue from subscriptions over one year, it is useful at the macro level for valuation,benchmarking, and multi-year forecasting. MRR, on the other hand,measures the expected monthly recurring business of your SaaS business. It helps you make decisions at the micro level that improve the day-to-day performance of your SaaS business. MRR—and its breakdown—is therefore an essential part of your monthly reporting.

So it’s worthwhile for SaaS managers to measure and track both ARR and MRR. The latter provides an operational and granular overview, useful for the day-to-day management of the company. Whereas ARR is a strategic indicator, which becomes increasingly important as the business grows, i.e., as the company matures, managers gradually move from monthly to annual monitoring.

How to improve the ARR of a SaaS?

KeyBanc Capital Markets’ annual study of SaaS results (conducted in 350 SaaS companies during 2021)highlights a median annual growth in ARR 2020 of 31%, across all company sizes.So, what are the levers at your disposal to improve your ARR growth?

The first step to increasing SaaS ARR is to measure and analyze current revenues and growth. Ask yourself where these revenues come from: acquisition channel, type of customer, type of product/service/offering.You’ll then be able to identify the most effective levers for increasing your ARR:

• accelerate acquisition via best-performing channels;
• reduce churn;
• increase ARPU (average revenue per user) through upselling.

These different levers can be identified by analytical segmentation by customer, product, geographical area, etc. That’s why it’s so important to set up a meticulous, up-to-date management system, fed by several sources of data.

You now know the importance of ARR for adapting your reporting and KPIs. Fincome is the partner of choice for SaaS companies. Book an online demo to see how you can build reliable, up-to-date reports of ARR and other SaaS metrics within 24 hours.

💡 Complete your reading with the following articles:

• 3 common mistakes that kill SaaS startups
• Automated reporting for SaaS: a quick guide
• KPI reporting at every stage of your startup
• ­Why is SaaS financial reporting still crucial for your startup in 2023?