SaaS businesses have a recurring revenue business model. This subscription model allows them to amplify their growth through continuous revenue inflow. As a result, ARR is crucial to analyze their recurring income each year.
Annual recurring revenue (ARR) is the continuous revenue generated for a company in a period of one year. Thus, having a good ARR for a SaaS business indicates that it is thriving.
If you are a business owner, you should always understand ARR and measure it accurately to analyze and understand your company's performance.
What is ARR?
Annual recurring revenue is the annualized form of monthly recurring revenue (MRR). ARR is a vital measurement to analyze the year-over-year revenue increase of subscription-based SaaS businesses. ARR helps assess the amount of contractually obligated revenue a SaaS firm generates in a year (i.e., no one-time fees nor one-off purchases should be included in the calculation of ARR).
SaaS companies and subscription-based businesses calculate the value of ARR to estimate what their customers will eventually pay them over the course of a year. If you have a SaaS company, the revenues are recurring and predictable.
You may have different subscription plans for your customers. Your customer accounts may be different in nature. Your customer may be an individual consumer or a company itself.
You can study ARR either in whole or in segments. In both cases, ARR is a potential metric that will predict revenues for you. On top of that, the wise analysis and study of ARR enable you to pinpoint flaws in your business strategy. Stick with us; we know what questions you have in your mind.
How to calculate annual recurring revenue?
ARR is calculated by multiplying MRR (monthly recurring revenue) by 12 - the number of months in a year.
ARR = MRR x 12
Where ARR is annual recurring revenue, and MRR is monthly recurring revenue.
For example, let us say that the MRR for a company is $1000.
So, ARR will be 1000 x 12 = $12000
The questions now are what MRR is and why we calculate ARR if we have already calculated MRR. And how we deal with the finances of our company when we have different subscription plans. And what if our customers churn or we cross-sell and upsell them?
We have already discussed monthly recurring revenue (MRR). For a quick review, monthly recurring revenue (MRR) is an estimated revenue per month. It is just the total amount of money a SaaS company makes in a month from sales minus customer service costs.
MRR is an indicator of short-term growth, while ARR indicates growth in the long term. Different SaaS companies provide different subscription packages and observe analytics in different metrics. It really depends on your business whether you choose ARR, MRR, or a combination of both.
ARR calculation helps you forecast revenue and pinpoints the areas where you lose revenue. There will be ARR growth if you are able to retain your customers and upsell and cross-sell them. And likewise, any revenue lost due to customer churn will decrease your ARR.
No matter whether you are a startup, a small SaaS company, or a B2B SaaS enterprise, you must strategically study your ARR to make the right decisions.
ARR vs. MRR
Revenues recur in almost all SaaS businesses. But all SaaS businesses have different contract values. The periods of subscriptions also differ. If you have customers whom you contract with for at least a year, you would always calculate ARR.
Some subscription models generate contractually obliged revenue, which means they only serve those customers who are going to stick to them for a specified period under the contract. For example, you legally bind your customers to have your services for a minimum period of 2 years. The payments can be made monthly, quarterly, or annually, however. You would always prefer ARR in that case.
But only a small percentage of SaaS companies acquire yearly contracts. Most SaaS companies create packages and offer a mix of monthly, quarterly, and annual subscriptions. Hence, they are able to calculate both ARR and MRR.
SaaS or subscription businesses that are more focused on monthly subscriptions and short-term revenues usually analyze their business in MRR metric. Conversely, SaaS businesses with yearly subscriptions or those who want to analyze their business on a longer timeline prefer ARR.
Why is ARR important?
What makes ARR essential is its ability to capture the essence of business growth. Below are a few more reasons for its importance -
ARR provides a broad picture of business growth
While MRR can provide a quick overview of short-term growth, ARR paints a more comprehensive picture of future growth. It lets you know how much revenue you will generate for your subscription company. You can utilize insights derived from ARR for long-term planning, corporate road mapping, and financial modeling.
ARR helps you analyze your product-market fit
ARR provides you with information about the newly acquired customers and the lost customers, i.e., those who canceled their subscriptions. ARR is perfect for analyzing whether you have a product-market fit or not. For example, if you roll out some new features in your product and your ARR decreases, this may indicate that your current target market is not liking the changes you made to your product. Hence, ARR for SaaS businesses is a good indicator of their product-market fit.
ARR singles out the faulty marketing campaigns
ARR singles out the marketing campaigns that are not performing well. You can calculate ARR in smaller segments according to the marketing campaigns. You can then easily distinguish the marketing campaigns with low ARR from that with high ARR. The marketing campaigns with low ARR need to be restructured.
ARR helps you detect customer churn
If your ARR decreases, it means you are losing your customers. Customer churn is high, retention is low, and those who retain do not provide you value. This also implies that you are not getting new customers. ARR alarms you to slow down, rethink, and come up with new plans and algorithms.
ARR is a good way to demonstrate your growth
As you expand your SaaS business, the company's ARR will be an excellent value metric to demonstrate your increased market share and revenue growth to investors and stakeholders. Many big SaaS firms utilize ARR to assess their overall business health and performance.
How to improve or increase ARR
There could be many ways to improve and increase the annual recurring revenue (ARR). But before we enlist them for you, there is a caveat: a user buys only what provides him with value.
You may think of charging a higher subscription cost to your service to increase your revenues.
Acquire new customers
Obviously, new customers entering your business means that your revenues are increasing. And in a subscription business, revenues do recur.
Upsell and cross-sell existing customers
When you solve your customers' real problems, you are in a position to upsell and cross-sell them. Upselling is when you convince your customers to upgrade them. And cross-selling is when you offer them custom solutions in the shape of add-ons.
Monetize your free users
You can easily increase your revenues if you monetize your free users.
Customers leaving you can plummet your revenues. Scale the churn rates down as low as possible.
ARR is an indicator that tells you how much money you will make in the ongoing year. You may study ARR in segments or as a whole. You, in both cases, can draw some conclusions from the data. The insights you get enable you to grow and transform your business's financial health.
You can focus on generating expansion revenue or reducing customer churn to improving your ARR.