Metrics are a fundamental tool for any business. The right metrics allow owners to track various business processes and understand whether they are progressing toward company objectives. We could even go so far as to say that metrics form the framework for success.
One of the most crucial metrics for SaaS companies is ARR, which offers an excellent business health overview. ARR is also helpful in determining a growth rate that will keep your company on the upswing.
Let’s take a look at the nuts and bolts of this vital metric.
What is ARR?
If you’re unfamiliar with the term, your first question is probably “What does ARR stand for?”
ARR is annual recurring revenue, though some people refer to ARR as the annual run rate. Whatever you call it, this metric refers to how much recurring earnings you can expect from existing subscriptions.
Looking at ARR is effective for gaining insight into your business’ year-to-year performance. It’s essential if you want to forecast growth correctly.
How is ARR Calculated?
Calculating ARR will look slightly different for every company, as it depends on factors like the complexity of your business model and your pricing strategy. But the formula is easy to understand.
Add the yearly subscription revenue amount to the dollar amount earned from expansion revenue. Next, subtract the dollar amount lost from cancellations, and there you have it. You can also calculate ARR by multiplying MMR by 12 (we’ll take a closer look at MRR below).
What Should ARR Include?
ARR should compromise revenue from all the subscriptions that your business acquired during a specific period. These include the following:
- All recurring items
- Account upgrades
- Account downgrades
- Lost monthly recurring revenue from churning
What Shouldn’t ARR Include?
It’s critical not to add non-recurring things to your ARR tabulation. Otherwise, your ARR will be inaccurate and not applicable. For example, do not include the following criteria in your ARR calculations:
- One-time fees
- One-time add-ons
- Initiation fees
- Credit adjustments
Why is ARR so Important?
ARR is a critical metric in helping you plan for your future for the short and long term.
From a management perspective, ARR tells you about the overall health of your business. It offers a high-level look at yearly progression, which provides valuable insights for product planning and defining long-term goals. ARR also paints a picture of how effective a business’s long-term strategies are.
From an investment perspective, ARR is a valuable tool for investors. They use it to compare company performance against its competitors (or against itself over time).
How is ARR Different from Revenue?
ARR and total revenue refer to two slightly different things.
The latter takes into account all of a company’s cash income, whether or not these earnings come from recurring sources.
ARR, on the other hand, looks exclusively at revenue obtained from subscriptions. This distinction is vital for SaaS businesses, as it makes it possible to identify the success (or lack thereof) of a business’s subscription model.
ARR vs MRR
Just as vital as understanding ARR meaning is knowing the difference between ARR and MRR, or monthly recurring revenue.
Monthly recurring revenue refers to the total of all subscription revenue as a monthly value. Most SaaS companies determine MRR by adding the total of all new business subscriptions and then subtracting any downgrades and canceled subscriptions.
In other words, ARR and MRR measure the same thing but over different time periods. ARR is calculated annually, and MRR is calculated monthly, which gives management differing looks at recurring revenue.
How Do You Use ARR?
Subscription-based companies use ARR for several things. The metric is actually one of the most critical for SaaS businesses, which use it for several applications.
To Quantify Company Growth
Because ARR is a predictable and stable metric, it is an excellent way to measure growth. A business can look at ARR over several years and gauge whether it’s progressing.
To Evaluate Your Business Model’s Success
ARR measures the bread and butter of a SaaS company: total revenue from subscriptions. Therefore, it is an excellent way to determine how successful the subscription model is.
To Forecast Revenue
Along with MRR, ARR is a useful forecasting tool. Management finds it easy to incorporate this baseline metric with more complex calculations for projecting possible revenue.
How Can You Increase Your ARR?
ARR is what keeps your company’s momentum going, which is why its growth should be encouraged. There are a few ways to increase your company’s ARR revenue.
Increase Customer Acquisition
The easiest way to up your ARR is the most obvious–get more customers. But aside from merely getting people to sign up for your service, a business should have both a low customer acquisition cost and an efficient acquisition strategy.
SaaS companies want to discourage churn as much as possible, which is why putting nurture and retention programs in place is critical. These programs help ensure that your product is aligned with customer values and keeps them from terminating the relationship.
Encourage Annual Commitments After the Right Try/Buy Period
You should allow a trial period just long enough for users to buy into the value of the service. Once they have made it through, most are comfortable paying for a whole year upfront. Just be careful not to offer too deep a discount for annual commitments. Stick to no more than a 5 percent price cut.
Use Growth Hacking
Growth hacking, or taking advantage of the marketing flywheel, is critical for increasing your ARR. Some ideas include adding features that force up-sells and including several ways for customers to refer others. Anything that uses the momentum of existing customers to encourage referrals or repeat sales is the goal.
As with all metrics, ARR is only useful within the right context. But when used correctly, this fairly simple measurement offers plenty of insight into your company’s growth. It’s also fundamental in helping you figure out how to maximize growth moving forward.