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17

May

How to Calculate and Use ARR to Grow Your SaaS Product

The annual recurring revenue (ARR) SaaS metric represents a business’ annual recurring revenue from term subscriptions normalized for one calendar year. It is calculated by subtracting lost recurring revenue from gained recurring revenue.

ARR is a crucial metric for SaaS businesses that want to focus on product growth because it provides valuable insight into product revenue.

This article will discuss what ARR is, how to calculate it, and how to optimize it for growing your SaaS business.

What is ARR (Annual Recurring Revenue)?

ARR is a metric used by SaaS or subscription-based businesses to measure the amount of revenue that is committed and recurring on an annual basis. It is the total amount of revenue a business receives from recurring subscription-based services in a single year. 

By calculating ARR, SaaS businesses can determine a predictable measure of revenue growth and forecast revenue more accurately. Let’s take a look at how to calculate ARR for your SaaS business. 

 

How Do I Calculate ARR for SaaS?

You can calculate ARR in one of two ways; by subtracting the annual revenue lost from subscription cancellations and downgrades from the annual revenue generated by upgrades, add-ons, and yearly subscriptions or by calculating MRR (monthly recurring revenue) and multiplying it by 12. 

Typically, the ARR for SaaS products includes any revenue from contractually committed, fixed subscriptions. To calculate ARR for SaaS, the subscription plans offered by your business should be for a minimum of one year. You should also include revenue from any upgrades, add-ons, or downgrades to subscription plans. 

 

SaaS ARR Formula

saas ARR formula calculation

 

1. The first ARR formula relies on annual revenue only and looks like this:

ARR = (sum of revenue from new subscriptions, add-ons, and upgrades) – (sum of revenue lost from cancellations and downgrades)

If the revenue for a SaaS business looked like this at the end of the year:

  • Revenue from new subscriptions: $10,000,000 
  • Revenue from add-ons and upgrades: $30,000
  • Revenue lost from cancellations: $30,000
  • Revenue lost from downgrades: $5,000

You would calculate ARR as follows:

ARR = ($10,000,000 + $30,000) – ($30,000 + $5,000) = $10,025,000

The ARR for this business was $10,025,000 for one year. 

 

2. The second way to calculate ARR is by first calculating MRR and then multiplying your results by 12: 

ARR = (Average monthly revenue per customer * Number of total customers) * 12

If a business generates an average monthly revenue per customer of $100 and the business has 250 customers,  the ARR would be calculated as: 

ARR = ($100 * 250) * 12 = $300,000

The ARR for this business was $300,000 for one year. 

By comparing the ARR for the current year with previous years, you can determine how quickly your business is growing. 

 

Important Figures For Calculating SaaS ARR

The most important figures to consider when calculating ARR SaaS are:

  • Customer revenue per year: This is the total revenue that a business accrues in one year from contractually committed subscriptions.
  • Subscription upgrades and add-ons: This is the total revenue from upgrades and add-ons to existing subscriptions. 
  • Lost customer revenue per year: This is the total revenue lost from customers who have churned. These customers have stopped using the product or service and let their subscription window close.
  • Subscription downgrades: This is the total revenue lost from subscription downgrades. While downgrades represent lost revenue, it also pinpoints customers who have not churned yet. This is an opportunity for you to upsell to customers and gain back revenue. 

You can freely calculate SaaS ARR using our SaaS metrics calculator.

 

What NOT To Include In Calculating SaaS ARR

What NOT to include in calculating SaaS ARR

Although there are no exact rules for what should be included when calculating SaaS ARR, it is important to make sure that you are including only recurring revenue. Here are a few examples of what not to include when calculating ARR: 

  • One-time fees: One-off or non-recurring fees such as set-up fees, late fees, or installation charges. 
  • Non-subscription revenue: Revenue that is generated from non-subscription sources, which include consulting fees or professional services.
  • Variable fees: Revenue that is based on variable factors, such as usage or transaction volume. 
  • Credit adjustments: Adjustments to revenue from refunds, discounts, or credits given to customers.
  • Training and support: Operating expenses such as training and support, as these types of expenses inflate ARR and provide an inaccurate representation of the company’s recurring revenue stream.

ARR for SaaS is exclusively used to measure recurring revenue, so including non-recurring revenue like the above can give you inaccurate data and profitability forecasts.

 

What is a Good ARR for SaaS?

Typically, a good ARR for an early-stage SaaS business is around $1M, while a mid-stage SaaS business should have an ARR of $5M or more. But note that it will look different for SaaS businesses depending on the company size, industry, growth stage, and business model.

An early-stage SaaS business will typically have a lower ARR because it must build a customer base, refine its product, and navigate scalability issues like expanding infrastructure. As the business becomes more established, its ARR should start to increase. 

Generating a good ARR will positively affect SaaS businesses for the following reasons:

  • Revenue stability: When your ARR is decent, it indicates that your business has a stable and reliable income, helping you to mitigate financial risks like customer churn or market fluctuations. 
  • Business valuation: ARR is a key metric for determining the value of a SaaS business. A good ARR leads to higher business valuations, making it easier for you to acquire new investments or negotiate favorable terms during mergers and acquisitions.
  • Scalability: A steady increase in ARR indicates a growing revenue stream that allows you to invest in scaling operations, like product development and marketing initiatives. 

 

Importance of Calculating ARR

Calculating ARR helps you to shape your business plan, drive strategic decision-making, and propel your success in competitive markets. Here are a few reasons why calculating ARR is so important for SaaS businesses: 

1. Shows Company Health

Calculating ARR can help you determine whether your company is growing and, if so, why. Having an accurate picture of company health can help you make better decisions regarding operational planning, and financial planning, and help you to improve your bottom line. 

2. Increase Revenue

ARR can provide you with valuable customer insights, helping you to promote add-ons, upgrades, and more expensive subscription packages. 

3. Revenue Forecasting

Tracking ARR helps to build an accurate picture of your company’s health and forecast revenue accordingly

4. Goal Setting

Tracking ARR also helps you to set realistic, achievable goals for investing in product growth and development.

5. Employee Retention

A high ARR is an indication that the business is stable and predictable, which increases job certainty. An increase in revenue also allows you to allocate more resources to employee compensation packages, employee well-being initiatives, and employee development initiatives, increasing employee satisfaction and, therefore, retention. 

5. Attract Investors

As highlighted earlier, a high ARR indicates that your business has a reliable and stable income stream that can be forecasted accurately. This is attractive to investors because they can sell predictably and systematically. 

Although ARR does not give the complete picture of a company’s success and profitability, it is important to track the health of your subscription-based services, and calculating ARR is one of the most accurate ways to achieve this. 

 

CRR vs. ARR For SaaS, What’s The Difference?

The primary difference between ARR and CARR lies in their scope and timing. While ARR gives an immediate view of the revenue from live contracts, CARR anticipates future revenue streams, including those from contracts pending activation. This forward-looking metric allows businesses to gauge their financial trajectory more accurately, factoring in both secured income and anticipated changes in their subscription base.

ARR measures the predictable and recurring revenue generated by a company from its active subscriptions within a year. It focuses solely on revenue from existing contracts, providing a snapshot of current financial performance.

Contracted Annual Recurring Revenue (CARR), on the other hand, broadens the perspective by including future revenue from contracts that have been signed but not yet activated. This metric encompasses anticipated revenue from new bookings, adjustments for expansions or contractions in services, and potential churn. By factoring in these elements, CARR offers a forward-looking view, projecting future financial stability and growth potential.

Both metrics are pivotal, yet they serve different purposes in financial analysis and forecasting.

Saas CARR vs ARR

While ARR is more concerned with the current state of the business, CARR is a more forward-looking metric. It provides an overview of revenue that you are contractually guaranteed to receive, which allows you to budget and set business goals accordingly. 

For example, if it takes 3 months for a new customer to be onboarded to your product, ARR will not account for the onboarding time. CARR is a useful metric to use in such cases because it shows the full picture of your revenue stream during that time period. 

Use the following formula to calculate CARR:

CARR = (Total recurring revenue from new subscriptions in a period) + (Recurring revenue from existing subscriptions at the beginning of the period) – (Churned revenue from existing subscriptions during the period).

 

ARR vs. MRR, What’s The Difference?

MRR vs ARR

 

The main difference between monthly recurring revenue (MRR) vs ARR is that MRR is calculated monthly, whereas ARR is calculated annually. 

As we’ve seen, both ARR and CARR allow you to measure year-over-year progression and are useful for predicting long-term growth and revenue. MRR, on the other hand, provides a more in-depth, month-by-month view of a company’s revenue. MRR is the sum of all monthly revenue, regardless of subscription contract length. It is key to understanding product-market fit, short-term momentum, and the trajectory of recurring revenue. 

ARR is a more widely used metric for SaaS businesses because it is more predictable and future-looking than MRR. However, if you want to focus on short-term planning or measure the impact of recent changes, MRR will give you a more in-depth view of your revenue stream. 

Due to the fact that ARR does not measure subscriptions that lasted less than one year, MRR can also be a useful metric for businesses that offer monthly subscription plans. 

Below we have outlined some of the most important things to consider if you want to switch from MRR to ARR.

 

Switching From MRR to ARR

Switching from MRR to ARR can help you to track your company’s financial health and provides a basis for forecasting future revenue.

The basic formula for ARR is MRR x 12.

While this may seem simple, are a few things to consider when switching from MRR to ARR:

  • Length of the contract: Some of your customers’ subscription plans might be in place for less than one year. ARR only accounts for subscriptions that are one year or longer, so it is important to only include revenue that is guaranteed for this time period. 
  • Accurate data: All data included in new ARR calculations should be accurately recorded and calculated, especially during the transition period. Unreliable data can cause inaccuracies in your financial reporting. 
  • Internal processes: During the transition period, it is important to align internal processes and systems with the new metric. This may include changes to pricing, billing, and customer relationship management (CMR) systems.
  • Growth stage: ARR measures a minimum of one year, so MRR is more applicable to new startup companies that need an in-depth understanding of product-market fit, short-term momentum, and the trajectory of recurring revenue. 

 

Committed vs. Contracted ARR

Committed ARR is the total amount of recurring revenue that a company receives in one year. This includes revenue from both non-binding verbal agreements and legally binding contracts. Contracted ARR, on the other hand, is the total amount of recurring revenue that a company receives from signed, legally binding contracts. 

Analyzing the gap between the two types of ARR helps you to understand the stability and reliability of non-binding vs binding contracts for your business. This information can aid in making informed decisions regarding resource allocation, sales forecasting, and overall revenue management strategies.

 

How To Grow Your SaaS Product Using ARR

Here are a few ways that you can use utilize ARR to grow your SaaS products and increase your business’ revenue: 

  • Increase customer retention: Calculating ARR helps to determine how a product aligns with customer needs. By making sure that your product stays consistent with what your customer needs, you can increase customer satisfaction and customer retention. 
  • Increase customer acquisition: Not only can ARR be used to increase customer retention, it also helps you to acquire new customers by paying specific attention to what new customers need from the product.
  • Address customer churn: ARR helps pinpoint where high churn is coming from and allows you to focus on product features that increase customer retention and acquisition. 
  • Optimize pricing strategy: Testing and analyzing different pricing models help to increase ARR. For example, promoting annual plans that have more benefits than monthly plans can entice existing customers to switch and new customers to opt for annual plans. 
  • Upsell to existing customers: Analyzing customer usage needs and identifying which add-ons and upgrades generate the most revenue helps to promote and upsell additional product features, increasing ARR. 

 

Forecasting Recurring Revenue

Forecasting recurring revenue is important for business planning and optimization. You can anticipate future revenue by implementing the following steps:

  1. Gather relevant data (customer acquisition and retention rates, average revenue per user, churn rates, etc.).
  2. Identify growth drivers (subscription plans, add-ons, and upgrades).
  3. Determine growth rates (which subscription plans, add-ons, and upgrades generate the most revenue).
  4. Calculate projected ARR.
  5. Monitor and update data to ensure your financial projections are accurate.

 

What Is SaaS ARR Growth Rate And How To Calculate It?

ARR growth rate refers to the change in annual recurring revenue over a given period. ARR growth rate is represented by a percentage, which indicates the financial health and growth of the business. 

It is calculated by subtracting the previous year’s ARR from the current year’s ARR, dividing the result by the previous year’s ARR and then multiplying the result by 100.

 

ARR Growth Rate Formula

SaaS ARR Growth Rate formula

 

The formula for ARR growth rate is:

ARR growth rate = ((Current year’s ARR – previous year’s ARR) / (previous year’s ARR)) * 100

 

This formula provides a percentage that represents the change in ARR from year to year. For example, if a SaaS business had an ARR of $1 million in the previous year and an ARR of $1.2 million in the current year, the ARR growth rate is 20%. This is a positive ARR growth rate, indicating that the company is in good financial health. 

Next, let’s take a look at a real-world example of ARR.

 

ARR Calculation Examples

ARR can be calculated using monthly, quarterly, or annual revenue figures. First, you need to calculate the average revenue for the time period by subtracting the sum of revenue from new subscriptions, add-ons, and upgrades from the sum of revenue lost from cancellations and downgrades.

 

1. To calculate ARR using monthly revenue figures, you can calculate the average monthly recurring revenue and then multiply your results by 12. 

For example, if a business’s average monthly revenue is $50,000, the ARR would be calculated as: 

ARR = ($50,000) * 12 = $600,000

 

2. To calculate ARR using quarterly revenue figures, you can calculate the average quarterly recurring revenue and then multiply your results by 4. 

For example, if a business’ average quarterly revenue is $250,000, the ARR would be calculated as: 

ARR = ($50,000) * 4 = $200,000

 

3. To calculate ARR using annual revenue figures, you would simply calculate the average annual recurring revenue by subtracting the sum of revenue from new subscriptions, add-ons, and upgrades from the sum of revenue lost from cancellations and downgrades.

 

4. Next, let’s take a look at a real-world example of ARR calculation.

Spotify is one of the world’s leading digital music, podcast, and video streaming services. It offers both paid and free services, with a whopping 195 million users choosing to pay for the subscription service as of the second half of 2022.

Spotify generated $8.460 billion, $7.135 billion, and $6.086 billion in revenue from its subscription services in 2021, 2020, and 2019, respectively. 

Let’s take a look at Spotify’s growth rate between 2019 and 2021:

(ARR2020 – ARR2019) / ARR2019 * 100

= ($7.135 billion – $6.086 billion) / $6.086 billion * 100

≈ 17.20%

(ARR2021 – ARR2020) / ARR2020 * 100

= ($8.460 billion – $7.135 billion) / $7.135 billion * 100

≈ 18.53%

In 2020 and 2021, Spotify experienced ARR growth, this indicates that the business is growing and earning more revenue each year.

SaaS ARR Metric – Conclusion

ARR calculates the growth of a SaaS or subscription-based service over one year. It is an important metric for any SaaS business that wants to focus on revenue growth and product optimization. 

In this article, we discuss the ARR SaaS metric and its role in driving product and company growth. By calculating ARR, and combining it with CARR and MRR, you will gain a comprehensive understanding of your business’s financial health.

Increasing your ARR is not only crucial for employee retention, revenue forecasting, and setting business goals, it also will make your business an attractive target for future investment.

If you want to learn more about using ARR as a metric for measuring your SaaS business’ growth, contact us today!

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Polina

Polina is the backbone of our internal systems' implementation and keeps the company united and focused on delivering plans and results.

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