18 Jun What is Run Rate?
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The concept of run rate is used to extrapolate financial results to estimate future revenues. For example, a new company may have sold goods of a value of $1 million in its first six months. Using this run rate, the company could say that it expects its revenues to be $2 million in its first year of operations.
At times, it may be necessary for a company to make a prediction about its financial results. A startup may need to convince prospective investors about the viability of its business model. A new division within a company may need to prove to its top management that the product that it has recently launched has gained the acceptance of customers.
What does run rate mean?
In situations like these, it is useful to talk about the results that are expected to be achieved in a full year of operations. But this is not possible if the firm or the division within the company has been in existence for a shorter period, say, three months.
The idea of a run rate is useful here. The company could take its revenues in a certain period, say, three months, and convert it into an annual figure. It could do this by simply multiplying its sales for three months by four to get a projected yearly sales figure.
However, this method of calculating future revenues has its limitations. Circumstances could change in subsequent months. A company may have enjoyed high sales in the initial period because customers may have wanted to try out its product. They could be dissatisfied with the quality and could refuse to make additional purchases.
The run rate could also give you an inaccurate figure of future sales if the product is seasonal. In addition to this, there are other factors that make this an inexact tool. The competition that a company faces could suddenly increase. A key set of employees may leave. All these factors could lead to the estimate arrived at using the run rate being widely off the mark.
The Financial Times, a leading newspaper that specializes in business and economic news, recently carried a report headlined: “Zendesk Surpasses $500M Annual Revenue Run Rate….”
Example of run rate
The news report goes on to explain that in 2014, the company’s revenues stood at $100 million. But, over the years, the sales figure increased as the company added new customers and increased revenues from existing clients.
At the beginning of April 2018, Zendesk announced that it expects the year’s revenues to exceed $500 million based on its run rate in the first quarter.
A company can use its run rate to estimate future revenues. But the method should be used with caution as there may be circumstances that prevent a firm from keeping up the pace of sales that it has registered in an earlier period.