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If you’re in the business of SaaS or another term subscription, chances are you know what ARR and MRR (Annual Recurring Revenue and Monthly Recurring Revenue) are. But do you know if you’re calculating your ARR correctly? Because there’s a good chance you may not be.
In fact, according to Jordan T. McBride of ProfitWell, after polling 50 Software as a Service companies, they found that two out of five companies weren’t calculating their ARR properly. These companies, McBride said, “were including or discluding something they shouldn’t be in their annual recurring revenue calculations.”
That’s a lot of miscalculations, which can lead you to under or over-estimate the trajectory and health of your business, and essentially misrepresent yourselves to investors, advisors, and your team. These things can damage your business and your reputation.
So how do you know if you’re calculating your Annual Recurring Revenue properly? We aim to guide you in the right direction with this article, so keep reading.
What Is Annual Recurring Revenue (ARR)?
If you’re new to term subscriptions or the SaaS world, you may not even know what ARR is. So allow us to give a quick explanation before we delve deeper into how to calculate Annual Recurring Revenue and why it’s important for your business.
ARR – or Annual Recurring Revenue – is an important metric for SaaS and term subscription businesses that allows them to calculate just how much yearly revenue they will generate from term subscriptions, contracts, and any other recurring billing they have.
Monthly Recurring Revenue (MRR) is how much generated revenue you receive on a monthly basis from the abovementioned billing cycles, and ARR is simply the annualized version of that. It’s primarily used to measure your growth year-over-year.
Why Is ARR Important For Your Business?
Annual Recurring Revenue is one of the most important metrics for your subscription-based or SaaS business. When calculated properly, it allows you to essentially predict your yearly revenue, track your growth, and ensure your business model is working.
According to the Corporate Finance Institute, these are the three main reasons why ARR is important for your business. Let’s take a deeper look at each of them.
Tracking Your Growth:
ARR is both stable and predictable. When you use this metric to calculate your year-over-year, you then have the ability to compare several years of Annual Recurring Revenue. Comparing ARRs allows you to see how your business is progressing and whether changes need to be made.
Annual Recurring Revenue is often used to forecast future revenue for your business. When you use your ARR as a baseline, you can incorporate it into other, more complex business calculations that will give you a projection of your business’s revenues in the future.
Evaluate Your Business’s Success.
ARR is used to calculate only that revenue generated by SaaS or term subscription services. This enables you to evaluate your business model and ensure that your subscription services are successful.
What Is The ARR Formula? How To Calculate Annual Recurring Revenue?
Calculating your Annual Recurring Revenue is not as intimidating as it may seem at first glance. The biggest thing to remember when calculating your ARR is that you only include fixed or committed subscriptions, and recurring billing cycles and fees. So leave out one-time or variable fees.
There are two main formulas to use when calculating your Annual Recurring Revenue. You can calculate your Monthly Recurring Revenue and then multiply that by 12 (for 12 months in a year), and that will equal your ARR, which looks like this:
MRR at the beginning of the month
MMR from new customers that month
MMR from upgraded customers that month
MMR lost from downgraded customers that month
MMR churn for that month
= True MMR.
MMR x 12 = ARR.
The second formula for calculating your ARR leaves out the Monthly Recurring Revenue completely and just focuses on your Annual Recurring Revenue. It looks like this:
Total dollar amount of yearly subscriptions
Total dollar amount gained from upgrades
Total dollar amount lost to churn
Annual Recurring Revenue
Have a look at some simple ARR calculation examples over at SaaSOptics.
How To Forecast ARR
We briefly mentioned forecasting revenue earlier on in this article, but let’s take a closer look at it now.
To accurately forecast your Annual Recurring Revenue, you have to look at the other metrics involved. These include, of course, your ARR and MRR, but those aren’t the only metrics you’ll need.
Forecasting your ARR also includes the calculations of your Customer Lifetime Value (CLV), your Customer Acquisition Costs (CAC), and your Customer Churn Rate. Billing Platform gives three scenarios to help you understand how using these metrics can allow you to forecast your ARR. Let’s take a quick look at them.
You’ve calculated your CAC and noticed an upward trend. This indicates that there are chances that can be made to your business and subscription models to lower your customer acquisition costs. Your CAC always needs to be at least slightly lower than your CLV, but you never want to underspend because that can jeopardize your Customer Lifetime Value.
“At the heart of the overall financial health of your organization, CLV provides the information needed to determine how much you should spend acquiring new customers (CAC),” says Billing Platform. It can help you find out what is causing your customer churn and what the effects of that churn are. It also allows you to see how any changes made to your services or products can increase or decrease the revenue you receive.
Customer churn happens, whether we want it to or not. Keeping an eye on your Customer Churn Rate allows you to determine patterns, like specific times of the year when customer churn rises. Knowing and being able to predict these patterns can help you be proactive in stopping churn before it even starts.
Tracking these metrics gives you a greater ability to forecast your annual recurring revenue with accuracy, reliability, and stability.
How To Grow Annual Recurring Revenue
Want to know how to grow your ARR? It’s actually pretty simple. Get more customers. We know that sounds silly, but in the end, it’s the truth. A constantly growing customer base means more annual recurring revenue.
If you keep your Customer Acquisition Costs low and find out new and effective ways to retain your old customers while still bringing in new subscribers, you’ll be well on your way to growing your ARR. Upgrades, upsells, and cross-sells are also great ways for a SaaS company to maximize the value of every subscription you sell.
What’s The Difference Between Annual Recurring Revenue And Annual Run Rate?
The difference between Annual Recurring Revenue and Annual Run Rate is pretty straightforward.
Annual Recurring Revenue, as we mentioned, is your yearly revenue generated from SaaS or term subscription-based services.
Annual Run Rate, however, is the annual revenue generated from all of your products and services. This means all one-time and variable fees as well, which Annual Recurring Revenue leaves out. All businesses that sell products or services have an Annual Run Rate, but only businesses that sell SaaS or subscription-based products or services calculate an Annual Recurring Revenue.
How Annual Recurring Revenue Influences The Value Of Your Company
Your Annual Recurring Revenue influences the value of your company in many different ways. If you compare several years of ARRs and note an upward trend, you can easily see that your business is progressing well, and your subscription model works. This shows customers and clients that you are a trustworthy company.
If you calculate your Annual Recurring Revenue correctly, you are able to offer an accurate business trajectory to potential investors and advisors, which will, in turn, increase your value to them, and make them want to start or continue to invest in you and your company. Accurately predicting your Annual Revenue Rate is one of the best ways to secure future investors and show your team and other advisors that you are trustworthy and your business has value.
Now that you know how to properly and accurately calculate your Annual Recurring Revenue, go out there and ensure that your business and subscription models have you set up for success. Visit us at Wingmate if you have any further questions or need anything. We’re always happy to help.
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