Annual recurring revenue (ARR) can be a critical metric for understanding the financial health of a company and forecasting revenue growth.
In this article, we’ll explain what ARR is, how it can be calculated, and why it’s a particularly useful metric for startups and small businesses. Additionally, we'll look at some common mistakes that businesses make when interpreting the results of an ARR calculation, as well as some tips for growing recurring revenue into the future.
What is annual recurring revenue (ARR)?
Put simply, ARR is the amount of revenue a company generates each year based on predictable, recurring charges to its customer base. Most commonly, ARR is used by businesses utilizing a subscription model, such as B2C streaming services like Netflix or Hulu, or contract-based B2B service providers such as software-as-a-service (SaaS) companies.
ARR is calculated by adding the total recurring revenue generated from customers on an annual basis, including through product upgrades and add-ons, and subtracting losses incurred through downgrades and cancellations, or churn.
Why is ARR important for small businesses and startups?
ARR is considered a key metric for virtually any subscription business or SaaS but can be particularly important if you’re running a smaller company or startup. As a new or relatively small organization, ARR will be one of a few reliable indicators of the overall health of your business.
Here are just a few specific benefits to consider:
As its primary and most essential function, ARR helps companies with financial forecasting, or accurately predicting future revenue. By knowing what to expect in advance, you can dramatically improve initiatives around financing planning & analysis, and have a better idea of how to manage cash flows and allocate resources throughout the company more effectively.
Being able to attract investors during your company’s early stages is essential for ensuring continued growth. Naturally, interested parties will need a reliable way to assess your business’s performance, and to determine if they can expect the business model to remain successful in the long term.
Evaluating the success of your business model
Launching a successful subscription business or SaaS company often requires a fair amount of trial and error. There will likely be room to improve your business model in the early stages, and calculating ARR will help reveal your strengths and pain points, and ultimately identify where adjustments should be made.
Annual recurring revenue formula
While the specific process will vary significantly depending on the complexity of the business model in question, a generalized formula for calculating annual recurring revenue is as follows:
Total value of annual subscriptions/contracts + recurring revenue generated from add-ons and upgrades - revenue lost from cancellations and downgrades = ARR.
To provide a better idea of the ARR formula should be implemented in relation to your specific business model, here is a more in-depth explanation of how to calculate ARR and the financial information that may be required:
How to calculate ARR
When calculating ARR, the first step will be to determine the total value of annual revenue earned from recurring subscriptions/contracts before any upgrades or cancellations have been factored in. This will be the base figure from which to make your final calculation and should be the easiest to derive from your company’s overall balance sheet.
Next, you will add all relevant expansion revenue and subtract losses from downgrades or cancellations. Here are some extra considerations to make when utilizing these figures to calculate ARR:
Adding expansion revenue
Expansion revenue is any additional revenue generated on top of a customer’s initial subscription or contract. Generally, expansion revenue is created by upsell mechanisms built into your subscription model, which give your customers the option to pay a higher annual rate in order to gain access to upgraded features or benefits.
If your business model also includes separate add-on features which generate a recurring charge, the revenue created by these features will also need to be added to your base figure. Importantly, you will need to be careful to exclude items like non-recurring add-ons, or features offered to customers for a one-time fee.
Subtracting lost revenue
In order to make an accurate ARR calculation, it’s critical to subtract all revenue lost from product downgrades or cancellations. A downgrade will be any instance in which a customer makes an adjustment to their service plan that results in paying a lower annual fee. For example, a streaming service customer who is paying for ad-free access to TV shows may decide to downgrade to a cheaper plan that includes advertisements.
A cancellation will be any time that a customer cancels their service and does not renew before the subscription expires. Cancellations factored into an ARR calculation will almost always contribute to your overall churn rate or the rate at which your customers are canceling their subscriptions without returning. Churn may be calculated differently when addressing monthly recurring revenue (MRR).
When you get an accurate read of the above figures, they can then be fed into the above formula to give you the final ARR. (To simplify this process, try using a free ARR calculator tool.)
Common mistakes made when interpreting ARR
While the formula for calculating ARR might seem relatively straightforward, mistakes happen frequently and often lead to false or misleading interpretations. Here are a few of the most common mistakes, as well as some brief tips on how to avoid them.
Mistaking ARR for cash flow
Maintaining accurate and up-to-date financial statements is critical for a growing business, and it’s not uncommon for ARR calculations to be factored into the wrong statement, resulting in a misleading picture of how funds are managed within your organization. Because recurring revenue is considered income, it should only be reflected in your income or P&L statement.
Pro tip: Subscription businesses and SaaS companies need effective ways to manage high volumes of financial data and recurring electronic transactions, and it can be incredibly challenging to parse this data and prepare financial statements using outdated technologies or accounting processes. Consider where financial accounting efforts can be improved, or where tools like automation can be applied to streamline management and eliminate human error.
Failing to subtract discounts
Many businesses take too broad a view of recurring subscriptions and calculate the value of all active users based on the normal, non-discounted annual rate (e.g. $100/year). However, if you have recently offered your customers a discounted rate or a promotion (e.g. 25% off the normal rate), these customers will need to be accounted for and you will need to adjust your ARR to reflect the actual total value of all subscriptions.
Pro tip: When determining your base ARR before adding expansion revenue and subtracting losses, begin with customers who are subscribed at the normal recurring rate. Once you have this number, calculate the total value of discounted subscriptions, add it to your initial base, and continue with the process from there.
Not accounting for late payments
Your customers won’t always pay on time, and ARR is meant to account only for reliable streams of recurring revenue. Therefore, customers who are currently late on their annual payment should be placed in the category of lost revenue, and the corresponding value should be deducted accordingly.
Pro tip: Separating subscription values based on factors like discounted rates or late payments can’t be avoided if you hope to get an accurate view of recurring revenue. However, the process doesn’t need to be as labor-intensive or time-consuming as you might think. Again, take a close look at your existing financial management processes and consider integrating an automation tool to categorize your customers based on relevant metrics in real time.
3 ways to boost annual recurring revenue
Having a positive ARR that is positioned for continued growth can be an attractive selling point to potential investors. Here are a few areas to focus on when attempting to boost your annual recurring revenue.
Reduce customer acquisition cost (CAC): The costs associated with generating new customers can add up quickly, and the more you spend to bring customers in, the less return you’ll ultimately realize on contracts and subscriptions. When you’re evaluating and interpreting ARR, you’ll want to compare recurring revenue with CAC and determine where factors like marketing spend can be reduced or more effectively leveraged to increase your ARR.
Increase retention/lifetime value of your customer base (LTV): As the total value that customers provide to your business, increasing the lifetime value (LTV) of your customer base is critical to boosting ARR. The most reliable way to grow your LTV is to focus on improving initiatives surrounding customer retention. This might mean optimizing user experience at the level of the application or offering a more personalized customer service experience.
Consider new upgrades to incentivize engagement: Upgrades can go a long way toward increasing your overall ARR. After performing an evaluation of the upgrades and add-ons your business currently offers, identify where new features might be added and integrated as part of a new subscription tier. Alternatively, depending on how active your customer base is, you may want to rethink your pricing strategy and adjust the price of certain services to reflect demand.
Take control of your finances with Ramp
The way your organization manages expenses and controls spending has a direct impact on your ability to turn a profit. Knowing that expense management is an increasingly complex task in today’s hyper-digitalized environment—particularly for startups and small businesses—Ramp created a card and platform that not only simplifies accounting processes but makes it easy to customize and enforce strict controls around employee spending.
In addition to earning cash-back rewards on recurring purchases, the Ramp card for small businesses and startups includes:
Automation tools to streamline invoice reconciliation: Invoice reconciliation is critical for startups and small businesses to maintain accurate and transparent account processes. Reconciling invoices manually, however, is time-consuming and prone to human error. With the Ramp card, everything from organization and receipt matching to identifying and removing discrepancies can be automated to make the process significantly more accurate and efficient.
Automatic categorization: As mentioned earlier, categorization is a huge part of calculating metrics like ARR, but it’s also where many businesses run into trouble. Ramp removes the tedium from categorizing transactions and expenses, and through its integration with your existing tech stack, the card allows transactions and invoices to be automatically placed into their relevant categories without the need for human intervention.
Easily customized spend controls: Due to a lack of transparency and enforceable controls, overspending can often become the Achilles heel of a burgeoning startup. Ramp’s spend controls are easily customizable, making it easy to authorize specific users to make purchases, as well as restrict spending to pre-approved products and vendors.
If you want to learn more about how the Ramp card can help your business optimize ARR and streamline expense management, click here to get started.