Annual Recurring Revenue and Its Importance

ARR is the abbreviation for annual recurring revenue, which is the revenue a company expects to generate from its customers by providing products and services. A company with a subscription-based model uses this metric to measure the progress and predict the company’s future growth. These companies use payment gateways such as PayU to accept customer payments. It also helps in measuring the number of new customers added, renewals, upgrades and customers lost.

ARR Calculation

Take an example of a company with one customer who took a 2-year subscription for Rs. 4000. Divide the total subscription amount by the number of years. Here, we will divide Rs. 4000 by 2, which means ARR is Rs. 2000 per year.

Repeat the same calculation for every customer when calculating ARR for multiple customers and add all the yearly amounts to calculate ARR. However, companies like to break down the total amount into individual ARRs. Some common components of annual recurring revenue are:

•    ARR added from new customers

•    Addition of ARR from renewals from present customers

•    Addition of ARR from upgrades from present customers

•    Loss of ARR from downgrades from present customers

•    Loss of ARR from churned customers

ARR Formula

ARR = Total amount of yearly subscriptions+ Total amount lost due to cancellations + Total amount gained from expansion revenue 

It is important to note that expansion revenue earned from upgrades and add-ons would affect the price of the annual subscription of a customer. Therefore, it is included in the ARR calculation and excludes any one-time options.

Importance of ARR

Subscription-based companies consider annual recurring revenue as the most important metric. It has much importance, which are:

• Quantifies the company’s growth: Due to its stability and predictability, it is a good measure of a company’s growth. A company can see if there is any progress because of its business decisions by comparing ARRs of multiple years.
• Forecast revenue: A company uses ARR for revenue forecasting. It is usually referred to as a baseline and can easily be included in complex calculations for projecting the company’s future revenues.
• Evaluate the business model’s success: ARR only calculates the revenues gained from subscriptions, unlike total revenue, which includes all the company’s cash flows. Therefore, ARR helps a company to identify if it is getting success from the subscription model or not.
• Increase revenue: Keeping track of relationship changes helps the company understand the needs and wants of a customer. It further helps in promoting up-selling and cross-selling, which increases the revenue.
• Attract investors: Generally, investors have a preference for a predictable sales model and precise revenue estimation of the subscription business over one-time sales. Therefore, subscription-based businesses can prosper because they can sell predictably.

Conclusion

Businesses with a subscription model use annual recurring revenue as a critical metric to measure the company’s growth. Using this data, a company can check the overall health of the business as well as the action it could take to increase or decrease the overall growth momentum. It is a compounding indicator of the company’s ability to grow. Without ARR as the baseline, a company can’t realize its continued success.

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