Wall Street Prep

Annual Recurring Revenue (ARR)

Guide to Understanding Annual Recurring Revenue (ARR)

Learn Online Now

Annual Recurring Revenue (ARR)

In This Article
  • What does the annual recurring revenue (ARR) measure?
  • Which formula calculates annual recurring revenue (ARR)?
  • How is ARR different from MRR?
  • Why is ARR important for a subscription business?

How to Calculate Annual Recurring Revenue (ARR)

ARR stands for “Annual Recurring Revenue” and represents a company’s subscription-based revenue expressed on an annualized basis.

While not a GAAP metric, ARR captures a SaaS company’s historical (and future) financial performance more accurately than the revenue recognized under accrual accounting standards.

ARR reflects only the recurring revenue component of a company’s total revenue, which is indicative of a SaaS company’s viability.

Typically, ARR is the primary metric used to measure the health of SaaS and other subscription-based companies with business models oriented around recurring revenue and multi-year contracts, particularly for forecasting year-over-year (YoY) growth.

Since ARR represents the revenue expected to repeat into the future, the metric is most useful for tracking trends and predicting growth, as well as for identifying the strengths (or weaknesses) of the company.

Annual Recurring Revenue (ARR) Formula

ARR is a company’s total recurring revenue as expressed on an annualized basis.

Conceptually, the ARR metric can be thought of as the annualized MRR of subscription-based businesses.

ARR Formula
  • ARR = MRR × 12 Months

Taken into account within ARR is the revenue from subscriptions and expansion revenue (e.g. upgrades), as well as the deductions related to canceled subscriptions and account downgrades.

In order to properly calculate the metric, one-time fees such as set-up fees, professional service (or consulting) fees, and installation costs must be excluded, since they are one-time/non-recurring.

For example, let’s say a customer negotiated and agreed to a four-year contract for a subscription service for a total of $50,000 over the contract term.

To calculate the ARR, we would divide the contract value ($50,000) by the number of years (4), which comes out to an ARR of $12,500 per year.

  • ARR = $50,000 ÷ 4 Years = $12,500

ARR vs. MRR

MRR, or the monthly recurring revenue, is the normalized revenue of a company expressed on a per month basis.

Like ARR, MRR only captures the revenue from active accounts on subscription-based payment plans.

When evaluating companies with short-term contracts that last less than one year, MRR is the appropriate metric to focus on.

Both KPIs are intended to measure the predictable and recurring revenue of a SaaS company, but ARR is more “forward-loooking” as it is commonly used to estimate revenue for future years.

Moreover, ARR is derived from the most recent MRR, which also represents the main drawback to ARR because this assumes that the most recent month is the most accurate indicator of future performance.

Annual Recurring Revenue (ARR) Calculator – Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

dl
Submitting ...

Annual Recurring Revenue (ARR) Example Calculation

Suppose we’re projecting the annual recurring revenue (ARR) of a SaaS company that ended December 2021 with $4 million in ARR.

The ending ARR will be equal to the beginning ARR plus the net new ARR, which is comprised of three factors:

  1. New ARR: The new ARR added from new customers acquired in the month
  2. Churned ARR: The lost ARR from customers that churned in the month (e.g. cancellations, non-renewal, downgrade)
  3. Expansion ARR: The additional ARR from the existing customer base (e.g. upselling, cross-selling)

For January 2022, we will assume that $200,00 worth of new ARR was brought in, followed by $250,000 in February.

  • January New ARR = $200,00
  • February New ARR = $250,000

In both months, the churn rate and expansion ARR will be estimated as 6% and 2% respectively.

  • Churned ARR (% Churn) = 6%
  • Expansion ARR (% Upsell) = 2%

The new ARR will be hardcoded for January and February, and then the beginning ARR will be multiplied by the respective churn rate and upsell assumptions.

  • January 2022:
      • Churned ARR = –$240,000
      • Expansion ARR = +$80,000
  • February 2022:
      • Churned ARR = –$242,000
      • Expansion ARR = +$81,000

Since we now have all the necessary inputs for the ARR roll-forward schedule, we can calculate the new net ARR for both months.

  • Net New ARR = $200,000 – $240,000 + $80,000 = $40,000
  • Net New ARR = $250,000 – $242,000 + $81,000 = $88,000

The ending ARR for January comes out to $4,040,000, which becomes the beginning ARR for February.

If we add $88,000 to the beginning ARR, we calculate the ending ARR in February of $4,128,000.

  • January Ending ARR = $4,000,000 + $40,000 = $4,040,000
  • February Ending ARR = $4,040,000 + $88,000 = $4,128,000

Annual Recurring Revenue (ARR) Calculator

Step-by-Step Online Course

Everything You Need To Master Financial Modeling

Enroll in The Premium Package: Learn Financial Statement Modeling, DCF, M&A, LBO and Comps. The same training program used at top investment banks.

Enroll Today
Comments
guest
0 Comments
Inline Feedbacks
View all comments
Learn Financial Modeling Online

Everything you need to master financial and valuation modeling: 3-Statement Modeling, DCF, Comps, M&A and LBO.

Learn More
X

The Wall Street Prep Quicklesson Series

7 Free Financial Modeling Lessons

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.