A run rate is a metric that uses a company's current financial performance to predict future revenue data. Business owners calculate the metric using existing financial information, assuming that the current performance will continue to create a yearly projection.
In this article, we’ll review the benefits and risks of using the run rate and unveil how to calculate and use the measure.
Benefits and Risks of Using the Run Rate
Newly created companies, various organizations, and established businesses use forecasting formulas like a run rate to predict future financial performance. After estimating the metric, business owners can take well-informed decisions regarding their marketing strategies, expenses, business expansion, etc. Although the run rate can’t guarantee that these predictions will be 100% accurate, they still help company owners make wise decisions regarding their business development. There are even more benefits entrepreneurs can reap after calculating and understanding the run rates of their businesses. The estimations help
- make financial performance estimates;
- create new profit departments;
- effectively make investments and spend money;
- evaluate the results of operational changes;
- shape budget;
- set the best price for the product.
However, besides the advantages, the run rate also carries several risks to business owners. You need to be aware of these limitations before using the metric.
Businesses from seasonal industries can’t rely on the run rate because of the fluctuating revenues of these businesses. They perform better in specific months, while the revenue is low in others. Entrepreneurs can't receive accurate results when calculating peak seasonal revenue data. Moreover, it can’t ensure that the financial performance will be as good as during the peak revenue periods.
The run rate doesn't take into account capacity constraints. A company might work at full capacity when calculating the measure. However, it can’t work the same way all the time. The revenue depends a lot on the customer demand within the market. If the demand reduces, the revenue drops.
The run rate might be irrelevant when combined with future trends. The financial performance of a company depends on changes within the market. For instance, if your product becomes more popular in the future, it might bring you huge income and encourage you to expand. Yet the situation will be different when your competitors prevail within this market.
Now that you understand the pros and drawbacks and still want to calculate the measure, let’s jump into the next section to unveil how to do it.
How to calculate the run rate?
This section is designed to show you the steps for estimating the run rate. Below we'll provide the instructions and an example, so let’s dive in.
- Identify the timeframe. The first step requires you to decide for which period you want to estimate the run rate. You can choose between a quarter and a year. After defining the financial period of your company, proceed to the process of gathering information.
- Collect relevant revenue data. Once you determine the time frame, you need to find appropriate data about your company's revenue. Your revenue data should correspond to the period you want to predict with the run rate. For example, if you want to predict business revenue for the next quarter, you should find revenue data for the same period in the past. However, you can still calculate the metric using revenue data for a month, but the result will be less accurate.
- Multiply the revenue by the chosen period. When you decide on the time frame and find the necessary revenue data, it’s time to calculate the run rate. Multiply your revenue during a specific period by the timeframe you’ve chosen. For instance, if you want to get the annual run rate, you should multiply by twelve.
Now that you have a step-by-step guide, it’s time to find out how to use this knowledge. Let’s discuss one example.
Say, there’s a startup that has been operating for a year. Its owner wants to calculate the run rate to predict future financial incomes and decide whether there’s a point in expanding the market. Let’s imagine that the company managed to make $30,000 per month. Let’s estimate the annual revenue for this business by using the run rate formula.
Annual run rate = $30,000 (revenue per month) x 12 (number of months in a year) = $360,000.
The company's expected annual income will be $360,000 if it operates with the same capacity and in the same marketing situation.
Now that you know how to measure the run rate, it’s time to find out how to use it. The next section will help you apply your knowledge and skills to reach business goals.
How to use the run rate?
New companies and organizations use the run rate to uncover the potential financial performance of a business. They can apply these estimations to make well-informed business decisions related to business expansion, expenses, operational changes, and marketing strategies. The run rate helps entrepreneurs decide whether to make alterations to their company operation, new product releases, or marketing strategy. They can also find out whether it’s the right time for additional investments and expenses.
Some businesses use the calculations to decide whether they need new financial departments. The run rate helps entrepreneurs determine their budget and the best product price.
Congrats, now you know all the essentials about the run rate. Hope that our instructions will help you calculate it.
Last Updated: 22.03.2023