Subscription-based models are among the most-widely used in businesses not least in the global Software as a Service (SaaS) market set to reach $308.5 billion by the end of this year.
The benefit of a subscription-based revenue is twofold: businesses get recurring revenue that they can rely on. Consumers get reliable service and can unsubscribe without much fuss. Underpinning this business model is Annual Recurring Revenue (ARR).
In this FAQ we will cover what annual recurring revenue is, its benefits as a reporting metric, and how it is calculated.
What Is Annual Recurring Revenue (ARR)?
ARR is a metric that attempts to value the recurring revenue components of various contracts. The practice of using ARR to forecast revenue and analyze profitability is dependent on the contracts being a minimum of twelve months. Usually, the metric includes only contractually committed and fixed subscriptions but there is no limitation on what can be included.
It is important to note that the various components that make up ARR do not necessarily conform to US GAAP. It is therefore not necessarily reliable as a source of earned revenue. ARR simply measures recurring revenue streams that are predictable.
Why Is ARR Important?
One of the most important uses of ARR is to measure and assess growth through the lens of the components that make up ARR. These components include:
● Increase in ARR as a result of new sales
● Retained ARR from subscription renewals
● Increases or decreases in ARR from upgrades, mid-term changes of agreements, or changes in renewal time
● Decreases in ARR due to customer turnover
Under the purview of finance, the ARR calculation is used to help identify growth. Finance professionals also use ARR to identify trends in contract average selling price. In addition, even though ARR is not an estimation of US GAAP revenue, it is used to help forecast and estimate future revenue under the guidelines of US GAAP.
How To Calculate ARR
The only prerequisite to calculate ARR is that contracts must be at least twelve months long. There are not any defined rules for determining which buckets belong in the ARR calculation, however, there are some commonly adopted policies.
Obviously, the source of revenue streams to include in the ARR calculation must be both recurring and estimable. For example, if the twelve-month contract is for $600 dollars, then the annual recurring revenue is $600.
For contracts that exceed one year, the contract value is annualized. In this case, the total contract value would be divided by the number of months in the contract and then simply multiplied by twelve to annualize it. For example, an eighteen-month contract that is worth $900 would have an ARR calculation as below:
ARR =ARR =900÷18=50 x 12 = $600
This example is also indicative of the deviation between ARR and US GAAP income recognition.
One limitation to note is that like MRR, irregular contract lengths can cause turbulence in the calculation.
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