Annual Recurring Revenue, or ARR, is a key metric used by subscription businesses or SaaS businesses that offer a defined length of subscription agreements. It is calculated by normalizing your term subscriptions’ recurring revenue components to one year. For example, an ARR of $6,000 per year would result from a two-year subscription for $12,000. Annual revenue is predictable and can be counted on every year.
Count the number of relative years in the total contract value. A four-year contract at $4000 may result in an average revenue per year of $1000 if the contract cost is divided by four (number of years). An ARR decrease of $3000 will occur if a customer does not renew his contract over two years for $6000 (contract cost).
One-time charges are not included in ARR, only fixed contract fees. A separate account should be kept for single charges (or variable revenue). Adding extra, non-subscription charges to ARR will result in inaccurate calculations.
When the subscription term is a year or longer, and regardless of how payments are structured, billing cycles do not affect ARR.
Profit over Investment Period / Number of Years = Average Annual Profit
Average Investment = (Book Value at Year 1 + Book Value at End of Useful Life) / 2
Imagine a SaaS company with $4 million in annual recurring revenue (ARR) at the end of December 2021.
Three factors contribute to the ending ARR, which is equal to the beginning ARR plus the net new ARR:
We will assume $300,00 worth of new ARR was brought in in January 2022, followed by $350,000 in February 2022.
New ARR, January = $300,00
New ARR, February = $350,000
We will estimate a churn rate of 6% and an expansion ARR of 2% in both months.
6% churned ARR (% Churn)
ARR (% Upsell) for expansion = 2%
ARR for January and February will be hardcoded, and the starting ARR will be multiplied by churn rate and upsell assumptions.
Churned ARR = –$340,000
Expansion ARR = +$80,000
Churned ARR = –$342,000
Expansion ARR = +$81,000
The new net ARR for both months can now be calculated since we have all the inputs for the roll-forward schedule.
Net New ARR, January = $300,000 – $340,000 + $80,000 = $40,000
Net New ARR, February = $350,000 – $342,000 + $81,000 = $88,000
This becomes February’s beginning ARR of $6,040,000 since the ending ARR for January was $6,040,000.
The ending ARR in February is $6,128,000 if we add $88,000 to the beginning ARR.
Ending ARR, January = $6,000,000 + $40,000 = $6,040,000
Ending ARR, February = $6,040,000 + $88,000 = $6,128,000