The ARR Advantage for Startups: Understanding and Calculating Annual Recurring Revenue

Contributors: Amol Ghemud
Published: December 23, 2022

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Introduction to ARR for Startups

For startups, ARR or Annual Recurring Revenue is one of the critical matrices that calculate the percentage rate of return that a business can expect over the life of an investment or asset in any financial year period. Fundamentally, ARR is the predictable revenue that a company earns annually from its customers.  

The starters need to keep the revenue model subscription-based rather than a one-time purchase. Every business looks forward to growing its ARR from time to time, and a decrease in the ARR of a particular segment means that the business has to rethink on its strategy. Be it investors, or the company’s management; ARR remains a crucial metric for all. 

ARR is known to be one of the widespread financial ratios and makes the decision-making process simple while comparing and selecting different projects. However, for long-term capital investments, ARR tends to be an insufficient method as it does not take into account the taxes, interest occurred, etc. The acceptance of a particular project depends if the achieved result is greater or equal to the desired ARR.

– Calculating Annual Recurring Revenue (ARR)

How to calculate ARR?

For some, ARR calculation may seem like a straightforward metric to calculate for a business over 12 months period. Nonetheless, ARR calculation depends on numerous factors that contextualize the overall growth of the business and can vary from company to company. ARR also includes the complexity and the pricing strategy of the business model. 

The annual net profit of an investment can be calculated as revenue minus annual expenses that occurred during the project implementation.

For fixed asset investments, like property, one needs to work out the depreciation expense from the annual revenue figure.

Lastly, one needs to divide the annual net profit by the initial investment or cost of the project and multiply the result by 100 to get the percentage value.

Simply put, Annual Recurring Revenue (ARR) can be calculated as:

Average Annual Profit to Initial Investment = Annual Recurring Revenue (ARR)

ARR is widely done to get a guide of how appealing the investment is and typically consists of only fixed and committed recurring fees or subscriptions. There are no specified rules for the determination of ARR. However, ARR may differ depending on a business’s contract term. Annual recurring value is essential as it helps companies get a brief insight into how flourishing their recurring revenue growth is. 

Importance of ARR Calculation

Annual Recurring Revenue is highly advantageous as it decides the project’s profitability. The best part about ARR is that it makes it relatively easy to understand the payback period by calculating the total savings over the entire period of the project. Small-time investors often use this method to appraise their investment decision as it enables them to compare various projects.

The Accounting Rate of Return is the simplest calculation to determine a particular project’s annual percentage rate of return. If the manager notices that the minimum required return of the project is greater than ARR, they will not go ahead with the project. Usually, ARR calculation is not just limited before accepting the proposal but is done year-to-year to keep a close eye on the returns from a specific project. 

Consider ARR as being a baseline where businesses can build more complex calculations. With the help of ARR, a company can create a reasonable picture of what the future would look like to them.

ARR is a magical metric that blesses businesses with a valuable context for future decisions. With it, one will find it easier to understand the real customer impact of the choices that they make for their business.

Closure

The Accounting Rate of Return remains a crucial metric for any business with a subscription model. The overall health of the business or the company concerning the actions that can be taken to increase or decrease the growth momentum is concluded by ARR. An increase in recurring revenue, in turn, helps the businesses create a better and thriving team to create the best products in the future.

FAQs

1. How do you calculate an ARR?

Simply put, there are two ways to calculate an ARR:

One is the most straightforward way, where one needs to add all the expected recurring value they may receive over a year.

The other one is to use the ARR formula, which considers various lengths of time customers have subscribed. This method paves the way for more accuracy, but the catch of using this method is that the overall calculation takes more time and information.

ARR Calculation formula:

ARR = Total revenue in a year for new subscriptions + Recurring revenue from existing subscriptions at the beginning of the year 

2. How do you calculate ARR growth?

ARR growth rate helps businesses gain an insight into the speed at which a company or a business is growing, along with identifying the potential that might come in their journey. The growth rate for SaaS businesses can be calculated by measuring the change in Annual Recurring Revenue (ARR) over time. The primary and first metric that one will refer to while calculating a company’s growth rate is the change in revenue over time.

Other Startup KPI Metrics

Understanding and Maximizing Monthly Recurring Revenue

Using ACV to Measure the Success of Your Sales and Marketing Efforts

Total Contract Value – A Key Metric for Evaluating Business Performance

Why Customer Lifetime Value Is the Most Crucial Metric for Your Business

The Importance of Accurately Calculating Deferred Revenue

Maximizing User Retention: How to Calculate Daily Active Users

Compounded Monthly Growth Rate: Understanding and Calculating Compounded Monthly Growth Rates

Calculating Your Company’s Total Addressable Market (TAM): A Step-by-Step Guide

Measuring Monthly Recurring Revenue: Expert Tips and Advice

Maximizing the Efficiency of Your Billing Process in Accounting

About the Author

Optimizer in Chief

Amol has helped catalyse business growth with his strategic & data-driven methodologies. With a decade of experience in the field of marketing, he has donned multiple hats, from channel optimization, data analytics and creative brand positioning to growth engineering and sales.

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