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Understanding SaaS metrics can be a bit daunting when you first look at your financial reports. Making sense of all the numbers is hard enough, but adding new acronyms like MRR & ARR into the mix can make the process even more complicated.
To spare you the headache, here’s a quick guide to help you make sense of subscription finance—starting with monthly recurring revenue.
What is Monthly Recurring Revenue?
Monthly Recurring Revenue, or MRR, is the expected normalized monthly revenue based on currently active subscriptions. Having a metric that’s closely tied to monthly revenue value is extremely helpful for providing insight into sales and cash flow dynamics.
Calculating Monthly Recurring Revenue.
The formula for calculating MRR is pretty straightforward.
MRR = # of customers * average billed amount
10 customers paying $150 a month equals an MRR value of $1500.
Fixed term subscriptions – Calculate MRR by normalizing your Annual Recurring Revenue (ARR) to a monthly rate. Just remember to subtract any one-time charges or fees to get a more accurate annual rate.
For example: ARR of $1200 / 12 month term = $100 MRR
Monthly subscriptions – Grabbing actual monthly subscription fees is acceptable in this case since your company is already billing customers each month to use your software or service.
Why is MRR an important KPI?
I know what you’re probably thinking, isn’t it enough to just depend on monthly revenue as a viable metric for the health of my company?
Yes, monthly revenue can provide your company with a general idea of how you’re doing, especially if your business model is focused on one-time sales. But for most software or technology companies, this isn’t necessarily the case since most plans are subscription-based. To get a holistic view of your company’s financials, you’ll need another KPI that already takes into account recurring revenue and varying subscription terms.
To help you visualize the importance of MRR and normalized monthly revenue – consider this scenario.
Your software company allows your customers to opt into one of two SaaS pricing plans:
- Plan A: A prepaid annual plan charging $1500.
- Plan B: A monthly “pay-as-you-go” plan charging $150 a month.
One of your customers has signed up for Plan A, and you currently have the rest of your customer base subscribed to the pay-as-you-go plan. In this example, we’ll assume that’s 10 users, so between Plan A and Plan B, you have 11 customers total. It’s the end of the first month and you’ve recognized $3000 in revenue [(10 customers x $150/month) + (1 customer x $1500/year)].
The second month comes around and you’ve only recognized $1500 in revenue for the month – that’s a 50% drop in revenue! But before you raise the alarm and panic, here’s what you actually need to know.
You can take a deep breath! Your company is still serving the same number of customers, (meaning there isn’t active churn) so there’s nothing to really worry about. If you remember from our example, we had one customer who opted into an annual contract. Your company is still serving 11 customers, but only recognize $1500 in revenue during this month because Plan A’s customer has already prepaid for an entire year of service.
That’s why normalized monthly revenue is so important, MRR provides a more accurate representation of the financial wellbeing of your business by accounting for different subscription terms.
Using MRR to Determine Subscription Business Health
Tracking MRR allows your company to:
- Conduct a cohort analysis
By increasing transparency on the performance of your subscription cohorts, you can better strategize how to optimize revenue.
- Calculate Customer Life-Time Value
Measuring the growth of each subscription contract also your business to proactively spot and prevent customer churn before it happens – further maximizing the value of each customer.
- Normalize subscription terms
Don’t let dissimilar subscription terms hold you back, normalizing subscriptions allows your company to better benchmark performance.
MRR & GAAP (Generally Accepted Accounting Principle)
Important disclaimer – while MRR is a powerful SaaS metric that will undoubtedly provide some clairvoyance into your business’s financial health, there are some things to keep in mind. Foremost, MRR is not a reportable GAAP revenue metric, and thus shouldn’t be factored into revenue recognition. MRR provides a powerful way to represent customer behavior to influence business decisions while reportable revenue is heavily ingrained in GAAP accounting rules – using one for the other can generate incorrect financial statements.
As long as your company takes these caveats into consideration, monthly recurring revenue is a valuable KPI that you can use to measure the performance of your business.
Stay tuned for the next article in our subscription finance series!