Let’s break this down.
ARR — Notice that instead of starting and ending with income, now we’re starting and ending with ARR, or annual recurring revenue. Again, that’s because this income statement looks forward, not backward. Whereas a traditional statement says “you made this much revenue in the past quarter,” this statement says “you are starting the quarter with this much recurring revenue.” That’s a huge quantitative difference. ARR is known recurring revenue that you can bank on.
Churn — Sadly, not all recurring revenue manages to recur. Even if you’ve got the best offering in the market, you’ll still have customers who leave you: If they’re a consumer they might get bored with your offering or switch to a competitor who’s offering them a shameless discount. If they’re a business you might lose your advocate, or they might get acquired or go under. Other reasons, of course, are more self-inflicted: poor adoption or utilization, product gaps, weak consumer marketing, a lack of resources and expertise. Regardless, this is called churn and is a reduction of ARR. So instead of being able to bank on $100 million, in this example the company subtracts a projected churn of $10 million to get a Net ARR of $90 million. This is what they can bank on. Now, how will they spend that money?
Recurring Costs — The first question is: what do we need to spend on to service that ARR? After all, your existing customers are expecting a service! Here is where we’ve rearranged some costs. We’ve pulled up COGS, R&D, and G&A to be “above the line,” in the sense that these are the costs you need to spend to service your ARR. Now, some companies or analysts do get fancy and try to allocate only some percentage of these costs as what is needed to service the ARR, but we decided to simplify things and assume that COGS, R&D, and G&A are all associated with servicing the recurring revenue. Hence, they are recurring costs. The benefit of this assumption is it makes it easy to benchmark against other public companies by using their available financial data.
Recurring Profit Margin — Your Recurring Profit Margin is simply the difference between your recurring revenues and your recurring costs. This number gives you the intrinsic profitability of your subscription business, as there is certainty in your recurring revenue as well as certainty in the costs to service that revenue. In the example income statement it’s $40, which represents a very healthy margin. There’s a lot of hand-wringing around how profitable subscription businesses can be. When we look at a subscription company’s financials, we always look at the recurring profit margin first, to get a sense of how strong the business truly is.