Forecasting sales and evaluating business conditions are essential for companies. There are many metrics that can be used to understand the current condition and forecast the future of your business. ARR is one of the most useful metrics to understand its growth potential.
In this article, we will explain the definition, calculation method, and factors of increase or decrease of ARR in a comprehensible manner so that you can understand it from scratch.
ARR (Annual Recurring Revenue) measures one year’s worth of fixed annual revenue.
It does not include initial costs, additional purchase costs, consulting fees, etc.
Therefore, ARR is not a suitable metric for businesses with large variation in monthly expenses or businesses that do not apply annual subscriptions to their services.
In evaluating business conditions, you need to focus on these three perspectives; “growth potential”, “efficiency”, and “customer loyalty (how much customers trust or are attached to a company or its products/services)”. ARR is an effective metric for measuring growth potential among these three, and since it is calculated based on the continuous and stable part of revenues, it can be used for simulating income and expenditure for the next fiscal year and beyond.
Sales can be roughly divided into two categories: recurring and non-recurring.
(1) Regular and periodical revenues (recurring revenue)
Recurring revenue represents “a revenue that is obtained from a company’s core business on a continuous and recurring basis each period”. A company’s core business can be, for example, book sales for a bookstore or delivery services for a delivery company, which represents the main part of a company’s business activity.
To begin with, “recurring” means something is always constant and stable, and is used as an antonym for “occasional”.
This indicates that recurring revenues are the segment of a business’ revenue that a company regularly earns each period from its core business, excluding “occasional”, highly transient revenues. Recurring revenue is a true representation of a company’s strength.
Example:
A person who uses a video streaming service is registered with an annual subscription and pays a monthly membership fee of ¥1,000, for a total of ¥12,000 per year. From the business’s perspective, unless something unexpected happens, that person is expected to pay the annual fee every year, so the ¥12,000 is a recurring revenue.
(2) Temporary and occasional revenues (non-recurring revenue)
Non-recurring revenue represents “a temporary or occasional revenue generated outside of a company’s core business”. You can basically assume that these revenues will not be generated more than once in the course of ordinary operations.
Example:
Suppose a video streaming service vendor holds a screening and sells 50 tickets at ¥2,000 each. The total revenue at this point is ¥100,000.
That company, however, doesn’t host screenings primarily as a business, and there is no guarantee that whether they hold a similar event, which would generate the same amount of revenue, the following year. As a result, the ¥100,000 earned from the screening is a non-recurring revenue.
MRR (Monthly Recurring Revenue) is a metric that measures a business’ fixed revenues earned on a monthly basis.
Both ARR and MRR are metrics of recurring revenues, however, the difference is that MRR represents one month’s revenues while ARR represents revenues gained per year.
In general, MRR is used for businesses such as music and video streaming services, where people subscribe on a monthly basis, in other words, there are always a certain number of monthly subscriptions and cancellations. On the other hand, ARR is often used as a metric for businesses such as enterprise SaaS vendors, in which annual subscriptions are more likely to occur.
When is ARR useful? The following two cases serve as a good example.
(1) To understand the top line of gross sales in SaaS businesses
Accounting revenue in the income statement could be an inappropriate metric of the top line in SaaS businesses.
In the case of a one-time purchase software businesses, revenues are basically recorded as a lump sum at the time of purchase, on the other hand, revenues of SaaS businesses are recorded on a prorated basis for each month of use.
For example, if a one-time purchase software vendor closes the books in March and sells a software worth of 2.4 million yen in the same month, the company would record 2.4 million yen in sales for the fiscal year. Whereas, in the case of SaaS businesses, if the subscription is annual, only 200,000 yen for one month of use would be recorded as accounting sales for the fiscal year.
In other words, accounting sales are a lagging indicator that is not suitable for properly evaluating SaaS companies’ capabilities at the end of the fiscal year. Therefore, for SaaS businesses, it is better to use ARR to measure the top line to properly assess the capabilities of the business at the moment.
*Note that ARR does not include non-recurring revenue, so it does not equal gross sales on the income statement.
(2) Calculating Valuation
Investors prefer metrics that accurately predict the future potential of a business. ARR is often used as the basis for valuing a company since it helps identify the growth potential and provides a high accuracy in predicting the future of a business.
Many startups need to raise funds through investments from VCs and other investors. In these cases, startups and investors negotiate with each other to calculate its market capitalization (valuation). ARR is often used in such cases. It is a very important metric especially for SaaS companies that are in need of fund-raising.
Since ARR can be calculated by multiplying MRR by 12, MRR needs to be calculated first.
MRR can generally be broken down into the following four components.
New MRR: MRR from new customers per month
Expansion MRR: MRR from customers who upgraded their plans from the previous month
Downgrade MRR: MRR lost due to customers who downgraded their plans from the previous month
Churn MRR: MRR lost due to customer churn per month
Based on these four components, MRR is calculated by the following formula.
Current month’s MRR = previous month’s MRR + {(A)+(B)-(C)-(D)}
ARR is derived from MRR using the following formula: ARR = MRR x 12
Note that if there is variation in MRR figures of each month, the derived figure of ARR will differ significantly depending on which months are used as the basis for calculating ARR.
To reduce the impact of such month-to-month variation of revenues, ARR can be calculated based on quarterly MRRs.
There are three possible approaches to increase ARR
(1) Increase the number of new customers
ARR can be increased by increasing the total number of customers. This means increasing the value of (A) in the above formula. However, the LTV/CAC ratio must be kept in mind so that the cost of customer acquisition does not exceed the generated revenue.
(2) Increase revenue from existing customers
Increasing revenue from existing customers is another way to boost ARR. It means increasing the value of (B) in the above formula.
Up-selling is to get an existing customer to switch to a higher-tier service or product, while cross-selling is to get them to purchase another service or product as one unit or a set.
As the “1:5 rule” states, “it costs five times more to acquire a customer than to retain a customer”, thus it is more efficient to increase ARR by up-selling and cross-selling than by acquiring new customers if a service is matured to a certain extent.
(3) Improve customer retention and reduce churn rate
If the number of customers is maintained, ARR will naturally grow as the number of customers accumulates each month. This equals reducing the values of (C) and (D) in the above formula.
The ratio of customers continuing to use a service is called the retention rate. To improve retention rate, you need to reduce stress customers feel when they use your service. People are more sensitive to discomfort than comfort. In order to have them continue to use your service, reducing the amount of times they feel “stressed out” is more important than to increase the amount of times they feel “happy” using your service.
While sales are used as a metric of a one-time purchase business model, ARR is used as an important management metric in the recurring business, especially in the subscription business, where revenue is generated on a continuous basis.
By understanding ARR, you can forecast future revenues, which helps develop management plannings.
