The Advantages of Compound Interest
Successfully managing fluctuating cash flows is a challenge for many small business owners. Seasonality, consumer buying power and the economic environment can all cause sales revenues to rise and fall. Sales are crucial for meeting working capital requirements. Not enough can leave a business unable to cover daily operating expenses and meet short-term debt obligations. When sales are good, saving or investing even a small portion of excess revenue in an account that pays compound interest can help maintain long-term profitability.
Compounding essentially amounts to earning interest on both the money you save and on the interest that money earns. For example, if a business invests $5,000 in a savings account, a money market account or a zero coupon bond that pays 5 percent annual compound interest, at the end of the first year the business will have $5,250 in the account. At the end of the second year, interest is calculated according to the $5,250 balance for a total account balance of $5,512.50. Every year the balance in the account grows according to the balance in the account including the interest paid for the previous year.
The longer money sits in a compound interest account the more it will benefit the business over the long term. How often interest is compounded makes a significant difference in the degree of the advantages that compound interest provides. An investment in which interest compounds annually will grow slower than an investment where interest compounds quarterly. A difference of only 1 percent in the interest rate can also matter. If the business invests $5,000 at 5 percent annual interest for five years the balance will be $6,416.79. At 6 percent, however, the balance would be $6,744.25.
Poor cash management is a major cause of business failures. To ensure a business can stay afloat, it not only needs operating and financing cash but also cash that it can invest back into the business. Investing money in compounding interest accounts can be part of a business’ long-term cash management plan. Forecasting can help a business determine when it will need to put money back into the business for equipment and other fixed assets that require large amounts of cash. Investing money in compounding interest accounts can be a source of funding large purchases.
Understanding the concept of compounding interest can be as important to saving money as it is to what the business can make from investing money. If a business routinely uses credit cards and doesn’t pay the balance in full each month, interest is most often calculated using compound interest. If the business carries a balance of $10,000 on a credit card charging 9 percent interest and pays $200 per month on the card, it’ll take 5.3 years to pay the balance and the credit will cost the business $2,580. Adding an extra $100 per month will reduce the payoff time by a full two years and reduce the total interest charged by $1,029.34.