Mastering the ARR calculation: a strategic guide

Reading Time: 6 minutes
mastering arr calculation blog
Annual Recurring Revenue (ARR) is a key metric for a company with a subscription business model, serving as a compass for assessing financial performance and growth expectations. However, the path to ARR determination is often paved with complicated paths and complex considerations.

In this in-depth presentation, we embark on a journey through the labyrinthine landscape of ARR calculations, meticulously dissecting various methodologies, providing illustrative explanations and engaging in a discourse on the merits and drawbacks of each strategy. By the end of the journey, you will have a firm understanding of the intricacies that underlie ARR calculations, enabling precise optimization of your company’s financial valuations.

ARR serves as an overarching metric that represents the predictable revenue stream of subscription-based businesses over a one-year period. Unlike GAAP measures, which refer to historical financial data, ARR is a forward-looking barometer used to evaluate a company’s financial performance and forecast future revenue streams. This distinction underscores the forward-looking nature of SaaS companies, for example.

Navigating the terrain of calculations: Methodological considerations

The basic formula for calculating the ARR may seem straightforward at first glance:
Some companies choose to calculate the ARR as 12 times the MRR (MRR = Monthly Recurring Revenue) as a practical alternative, as this is simple and efficient, especially for companies working with monthly subscription models:

ARR = 12 * MRR

Building on the ARR, subscription companies also like to report the “Contracted ARR” as a measure of sales success based on the subscription contracts already concluded that will only start in the future vs. the recurring revenues that will be lost in the future due to contract terminations or reduced payments.

However, applying the basic ARR formula to real-life scenarios can be very complex, even if currency effects are excluded from the analysis for the time being.

Let’s go through the 9 most common hurdles that also apply to the “Contracted ARR”:

1) Services: Include or exclude recurring service add-ons

Exclusion of recurring services from the ARR calculation:
Benefits:
  • Enables a clear distinction between core subscription revenue and additional services.
  • Simplifies the ARR calculation by focusing exclusively on the basic subscription component.
Disadvantages:
  • May inadvertently underestimate total revenue potential, especially if professional services are a significant contributor to the organization’s recurring revenue.
  • Does not capture the entirety of revenue from bundled subscription and service offerings.
A good compromise is, of course, to include the services directly in the subscription, for example in the form of quotas. The advantage of this is better recognition as software revenue.

2) Different contract terms: Include annual and multi-year contracts or those with shorter contract terms

Include only annual and multi-year contracts:
Benefits:
  • Prioritizes long-term revenue commitments, providing a more accurate representation of predictable revenue.
  • Consistent with the resilience and continuity that characterize subscription-based businesses.
Disadvantages:
  • Disregards projected revenue from shorter-term contracts, which can represent a significant portion of the customer base. Contracts are often renewed on a monthly basis, for example, with revenue per month possibly even increasing.
  • May underestimate the immediate impact of monthly subscriptions on the company’s financial position.

3) Projected versus confirmed revenue: Inclusion of delayed renewals in the ARR

Ausschluss von erwarteten, aber verzögerten Verlängerungen aus der Berechnung der ARR:
Benefits:
  • Provides a conservative estimate of the ARR by only considering existing contracts that have been officially renewed.
  • Reduces the risk of overestimating revenue from expected renewals that may not materialize.
Disadvantages:
  • Could underestimate actual ARR if historical data indicates a high probability of delayed renewals.
  • Neglect of revenue that is highly likely to come from upcoming renewals.

4) Inclusion of expected but not yet confirmed renewals in the ARR calculation:

Benefits:
  • Provides a more optimistic and holistic view of ARR as potential revenue from expected renewals is included.
  • Provides a more accurate representation of the company’s revenue potential, especially in cases characterized by a high renewal rate for late contracts.
Disadvantages:
  • Involves a degree of uncertainty as expected renewals do not always materialize, potentially inflating revenue estimates.
  • Requires a comprehensive understanding of customer renewal patterns and reliable data for accurate forecasting.
Ultimately, the calculation also depends on whether customers have to actively cancel or actively renew the contract. As the automatic renewal model is becoming increasingly popular, this also ensures that future ARRs are typically included after renewal, even if these are associated with an increase in the ARR, for example by reducing discounts for the first year.

5) Exclusion of usage-dependent sales

Exclusion of usage-dependent prices or sales from them from the ARR calculation: Benefits:
  • Simplifies the calculation process by focusing exclusively on basic subscription sales.
  • Avoids potential complexity and inaccuracies arising from variable usage fees.
Disadvantages:
  • May not reflect full revenue potential, especially if usage-based revenue and consistent overages play an important role in the organization’s revenue stream.
  • A key aspect of revenue generation is not considered, which may result in an incomplete financial assessment.

6) Inclusion of usage-based sales

Benefits:
  • Provides a comprehensive view of revenue by including both base subscription fees and additional revenue from usage fees and consistent overages.
  • Reflects the actual revenue potential, especially in scenarios where usage-based pricing has a significant impact on the company’s financial position.
Disadvantages:
  • Introduces unpredictability as usage fluctuations can make revenue more variable and difficult to predict, potentially impacting ARR and complicating financial projections.
  • The inclusion of usage-based pricing and overages can increase the complexity of the billing process, which can lead to errors.
  • Control of customer activation dynamics: inclusion or exclusion of contracted but not yet active customers from the ARR calculation

7) Exclusion of contractually bound but dormant customers from the ARR calculation:

It is quite possible that customers are currently pausing their subscriptions or not paying for them. The reasons for this are financial difficulties and the associated deferral of subscriptions, suspension of the subscription as a gesture of goodwill or as a form of compensation.
Benefits:
  • Enables a conservative ARR estimate, as only customers who actively use the product or service are taken into account.
  • Reduces the risk of overestimating revenue by excluding potential customers who do not activate their contracts.
Disadvantages:
  • May underestimate revenue potential in scenarios characterized by minimal time intervals between contract signing and go-live combined with a high probability of activation.
  • – Does not capture expected revenue from contract customers who are about to activate their subscriptions.

8) Treating early renewals that overlap with existing contracts as separate contracts without extending them:

Sometimes subscription contracts are associated with an increasing price per year or an increasingly reduced discount. In addition, an extension of the subscription, for example in the form of additional modules or additional users, may have already been agreed at the beginning but is not yet reflected in the initial subscription.
Benefits:
  • Maintains a clear distinction between existing and renewed contracts, enabling better tracking of revenue streams.
  • Minimizes potential confusion or overlap in revenue allocation during renewal epochs.
Disadvantages:
  • May not accurately reflect the continuous revenue stream from early renewals that overlap with existing contracts.
  • Requires close monitoring to ensure accurate tracking and reporting of overlapping renewals.

9) Extend early renewals that overlap with existing contracts and combine into a single contract:

Benefits:
  • Provides a more comprehensive view of revenue by recognizing the longer commitment and continuity associated with early renewals.
  • Reflects actual revenue generated during overlapping renewal periods, ensuring accurate financial valuations.
Disadvantages:
  • Requires meticulous analysis and consideration of contract terms and renewal periods to accurately determine extended revenue.
  • Can complicate tracking and reporting during overlapping renewal periods.

ARR vs. contracted or committed ARR

In addition to the ARR, i.e. the “Booked ARR”, a distinction must be made between the “Contracted ARR” or “Committed ARR” (CARR). The annually recurring revenue (CARR) is contractually defined revenue that applies regardless of whether the service has already been provided or is still outstanding. CARR is therefore a measure of sales success. The reconciliation from ARR to CARR is described in the figure below.

It is important to note that CARR is a snapshot in time, comparable to a balance sheet item, as opposed to turnover, which covers a specific period of time. CARR can be reported at any point in time, whereas sales figures must relate to specific time periods.
Bridge from ARR to contracted ARR
Figure: Bridge between ARR and Contracted ARR

Conclusion: Preparation for any due diligence by professional investors

Calculating ARR is an essential exercise to understand the financial health and growth trajectory of subscription-based businesses. However, the inherent uncertainties of ARR calculations require careful consideration of various alternatives, accompanied by a careful weighing of their respective pros and cons. By tailoring the calculation approach to the specific needs and objectives of the business, one can ensure that accurate and meaningful insights into recurring revenue streams are obtained. Ultimately, optimizing ARR calculations enables the provision of information.

It is important for investors to maintain a consistent definition to ensure comparability over time. The selected definitions should always be stored to ensure the necessary traceability. It is also essential to automate reporting in order to avoid calculation errors.

Share:

Table of Contents

Book a demo

Start today to better drive the direction of your company with ValueWorks!

More Posts

Share This Post

More to explore

Book a free demo

Schedule your personalized demo now

Want to know more?

What is your name?
What is your email?
What is the name of your company?
What is your role in this company?