When you buy through affiliate links in our content, we may earn a commission at no extra cost to you. Learn 
What is Annual Recurring Revenue (ARR)?
Annual recurring revenue, abbreviated as ARR, is a financial metric that measures a company’s expected revenue from customers over a given year.
Key Takeaways
- Annual recurring revenue is a financial metric businesses can use to project their future revenue.
- It’s generally used by companies with consistent revenue streams, like subscription plans.
- ARR can help companies make better business decisions and project future earnings
- ARR doesn’t account for the time value of money and isn’t useful for companies with sporadic or seasonal revenue streams.
- Along with other metrics, ARR can be used by investors to help assess a potential investment’s long-term viability.
ARR Importance
A company’s annual revenue is the income it needs to pay for expenses, grow its business, pay back debt, and invest in future projects.
Therefore, being able to accurately predict future revenue can be important. This makes ARR a useful tool for businesses with steady income streams.
How to Calculate Annual Recurring Revenue
Here is the basic formula that can explain how to calculate ARR:
ARR = (Number of customers) × (Average monthly subscription cost per customer) × 12
While this simple ARR calculation is useful, businesses often break down ARR into different categories that can impact their yearly revenue.
For example, a business with a subscription-based model may include the following in its ARR calculation:
- ARR added from new customers.
- ARR added from current customer renewals.
- ARR added from current customer upgrades.
- ARR lost from current customer downgrades.
- ARR lost from lost customers.
Real World ARR Example
Imagine you are a company offering a software as a service (SaaS) subscription model. You offer multiple plan options, and customers can upgrade or downgrade their plan as they see fit. Your Basic Plan costs $50 per month, and your Premium Plan costs $100 per month.
Here are your assumptions about your customer base over the year:
- Current Basic Plan customers = 50
- Current Premium Plan customers = 30
- Renewal rate = 90%
- Upgrades = 10
- Downgrades = 5
- Plan cancellations (churn rate) = 10%
Given these assumptions, here is how you would calculate ARR.
Basic Plan monthly recurring revenue (50 Customers)
50 x $50 = $2,500
Premium Plan monthly recurring revenue (30 Customers)
30 x $100 = $3,000
Total starting monthly recurring revenue
$2,500 + 3,000 = $5,500
ARR Calculation
$5,500 x 12 = $66,000
Calculating New ARR
Renewals (Renewal Rate = 90%)
Basic Plan: 50 x 90% = 45
Premium Plan: 30 x 90% = 27
Upgrades (Total Upgrades = 10)
New Basic Plan count: 45-10 = 35
New Premium Plan count: 27 + 10 = 37
Downgrades (Total Downgrades = 5)
New Basic Plan count: 35 + 5 = 40
New Premium Plan count: 37 – 5 = 32
Total customer count = 72
Plan cancellations (Churn Rate = 10%)
Lost customers: 72 x 10% = 7.2 (round down to 7 customers)
Assume:
4 customers lost from Basic Plan
3 customers lost from Premium Plan
Final Customer Count
Basic Plan: 40 – 4 = 36
Premium Plan: 32 – 3 = 29
Recalculation of Monthly Recurring Revenue
Basic Plan: 36 × $50= $1,800
Premium Plan: 29 x $100 = $2,900
Total MRR: $1,800 + $2,900 = $4,700
ARR Calculation
$4,700 x 12 = $56,400
Therefore, while your company’s ARR started the year at $66,000, it’s expected ARR when the year ends will be $56,400.
This decline in ARR is a bad sign for the business and potential investors.
ARR vs. MRR
| Feature | Annual Recurring Revenue (ARR) | Monthly Recurring Revenue (MRR) |
|---|---|---|
| What is it? | Expected predictable revenue annually | Expected predictable revenue monthly |
| Calculation | ARR = MRR x 12 | MRR = ARR / 12 |
| Uses | Long-term revenue forecasting and planning | Short-term revenue tracking and maintaining necessary cash flows |
| Useful for | Annual budgeting, financial statements, long-term growth analysis | Financial health check, operational decision-making |
| Reporting | Annual report to shareholders | Internal performance reports |
5 Ways to Optimize Your ARR
- Reduce churn rate: Provide customers with a better experience so they stay with your service for longer.
- Automate customer renewals: Allow customers to opt into renewals automatically with reminders.
- Expand your customer base: Target your marketing efforts to new customer bases in different geographies or customer segments.
- Change your pricing strategy: Offer dynamic pricing models or feature-based pricing.
- Win back lost customers: Re-engage with lost customers with incentives to win back their business.
ARR Use Cases
ARR Limitations
ARR can be a valuable tool for businesses. However, it has several limitations that you should keep in mind before using it to make business decisions.
Maybe most importantly, ARR doesn’t account for the time value of money. In the ARR calculation, revenue is accounted for the same value throughout the year, when in reality, inflation and other factors (like the opportunity cost of lost capital) mean that money received today is more valuable than money received at the end of the year. However, ARR does not take this into account.
Additionally, ARR only accounts for recurring revenue and therefore isn’t useful for businesses that generate one-time revenue streams or add-on product sales.
It also doesn’t factor in seasonal businesses, which generate a majority of their revenue during one period of the year. It also assumes many constant values, like churn rate and customer behavior, that usually aren’t consistent throughout the year.
The Bottom Line
Based on the definition of annual recurring revenue, businesses with predictable and regular revenue streams can use the financial metric to make better business decisions.
Investors can also use ARR to help value a company and determine whether its growth is steady.
Still, ARR isn’t a good tool for companies with unpredictable or seasonal revenue streams, and it shouldn’t be the only metric used when making an investment or business decision.
