Annual recurring revenue (ARR) is simply the total amount of money a company receives annually from its customers for subscriptions and other services related to its main product or products. Annual revenue is typically reported on income statements and balance sheets, but ARR adds another layer of detail and specificity by showing how much of that annual revenue comes from subscription-type services.
What Are the Components of ARR?
ARR is similar to, but not exactly the same as, a measure called customer lifetime value (CLV). In general, CLV shows you what a company’s average revenue from each of its customers is over the entire time they are customers. For example, if someone signs up for a service worth $100/year, has an ARR of $100, and remains a customer for five years, then their average revenue per year is equal to 100/5 or $20.
ARR takes the concept of CLV one step further by also breaking down that revenue into the amounts brought in on an annual basis from new customers and from existing customers. Existing customers might be paying their normal subscription rate, but new customers might be signing up for introductory offers with lower rates (or even full free trials). Thus ARR indicates how much revenue a company can expect to bring in over the coming year both from its existing customer base and its new signups.
How Is ARR Calculated?
ARR only works when the company has an established customer base that is paying for regular service or product use. Thus, if a new company is just getting off the ground and does not yet have any customers, it can’t take any money from them (let alone count it in its revenue figures) until it has actually brought those customers on board.
Once a company has an established customer base, however, the calculation for ARR is quite straightforward: Find out how much revenue each individual customer brings in and add up all of those numbers. This can be done on a monthly or annual basis (or whatever time period makes sense based on the company’s business model).
The point of doing this calculation is to show how much money the company can expect to receive in total over the next year or whatever time period makes sense for its business. It does not include any expenses that may be associated with servicing those customers (such as costs for staff, customer service reps, servers, and so forth) or show how much of that revenue is profit.
A company only has an established customer base when it has at least one paying customer who will provide money over a period of time (usually on a recurring basis).
Why Is ARR So Important?
Many companies emphasize or focus specifically on certain key performance indicators or metrics. ARR is definitely one of these – it’s a valuable number for many companies to keep track of and can lead to a better understanding of how successful they are in the marketplace.
Typically, a company must have a certain amount of revenue coming in before analysts will consider it viable or before investors will put money into it. The traditional investment model is that a company should be able to show a track record of at least three years with a certain amount of revenue coming in every year. This allows investors to get an idea about the company’s potential for growth, while also hopefully allowing them to see some return on their investment from the money they put into it.
Some companies can use ARR to show investors that they have the potential for a high rate of growth in the coming years, either from bringing in new customers or from having existing customers become even bigger spenders. In fact, some companies provide something called a five-year compound annual growth rate (or CAGR), which shows the expected exponential future growth of a company.
It’s important to remember that ARR can vary greatly based on the kind of company it is, the industry in which it operates, and other factors such as how many existing customers there are and what sorts of services they’re paying for. For example, a computer manufacturer would most likely only have an ARR figure once it has established a customer base because it’s only getting paid once someone has bought one of its machines.
A company that offers consulting services, on the other hand, can expect to make money from new clients over and over again (though typically not every month). With this in mind, these companies would most likely track their ARR figure by including both new signups and their corresponding subscription fees.
