How Can Businesses Use The Power of Compounding?

The concept of compounding is probably familiar to you. It’s a term that banks or lenders use to describe the process of growing interest. If you have deposited money into your bank account or have taken out a loan, you’ve most likely heard about compound interest. Basically, it’s the interest added to the interest of your savings or debts over a certain period.

Compounding has other aspects that are applicable in business settings. However, only a few entrepreneurs use it to achieve long-term financial success. To reap the benefits of compounding, you need to understand how it works.

Are you wondering how compounding can make a difference in your business profits, cash flow, and performance in general? Read on to discover the power of compounding and how your business can use it.

What Is Compounding and How Does It Work?

Compounding refers to the rising value of an investment or asset as a result of the interest earned on its principal and accrued interest. Out of that process, compound interest is acquired. If the interest rate is higher, you can expect a higher return. But with compound interest, the time value of money is essential.

It means that the value of money changes depending on when you will receive it. Besides the interest you earn on the principal amount, your investment length also matters in compounding. However, it should also be noted that compound interest applies both in assets and liabilities.

To understand it better, take a look at the following:

Compound Interest in Liabilities

When you use your credit card and don’t pay off the full amount on the initial due date, you are putting yourself up to pay compound interest.

For instance, you have a principal balance of $200, and the interest charge for the missed payment is 5%. The $10 ($200 x 0.05%) interest will be added to your principal balance, which would now be $210. If you miss another payment, another $10.5 ($210 x 0.05%) interest will be charged from the new balance. It will continue to grow if you keep missing payments.

Compound Interest in Assets

The compounding effect in assets works in a similar way. But here, you would be getting the compound interest as a return instead of a charge that you’ll need to pay off.

Let’s say you have $200, and it earns 5% interest every year. At the end of the first year, you’ll have $210. Then you’ll have $220.5 at the end of the second year. The compound interest will continue to add up over the years. As the frequency of compounding increases, the compounding effects are also strengthened.

How To Use Compounding To Your Business Advantage

For your business, you would want to minimize the liabilities as much as possible. That’s why it is essential to look for ways on how to grow your business profits.

You already know that compounding has the potential to increase the value of assets through compound interest. But how can you use it to improve the earnings and performance of your business?

Focus On Value Before Volume

There are two ways to make a sale on your business. You can create a large base of loyal customers by focusing on volume. Or you can bank on value, serving a small yet highly profitable group of customers.

When you focus on value before volume, you’re providing products and services with the optimal gain rather than chasing numbers. Although you’re targeting a small group of customers, you’re accumulating a certain profit over time. Remember that compounding has the potential for loss. By doing this, you can maximize your compounding returns.

Drive Appropriate Affordability in Pricing

Pricing is the most vital aspect of your business. Although affordability is essential to customers, it doesn’t mean giving away your profit. Many businesses reduce profitability due to discounts and their reluctance to increase prices. Doing this can result in negative returns.

However, maximizing profit on every single sale is essential. Even if the gain is only 1%, it can make a significant difference eventually. Thus, don’t hesitate to make necessary small and regular price increases. Many customers put the quality of the product or service above anything else. You can develop them as the key promoters of your business.

Maintain Prompt Payment of Creditors and Debtors

Paying your creditors in a timely manner is vital. It doesn’t only strengthen your relationship with them but also reduces your company’s liabilities. Since it could mean fast delivery time from your suppliers, you can make smaller yet frequent orders. It can give you more flexibility in meeting changes in your customer’s demand and keep your costs under control.

Cash is the king of your business. Thus, ensuring that your debtors pay on time is also important. Delayed payments from customers may result in compound cash flow issues. To avoid this, prioritize those customers who make payments on time. Debts owed to your business are still assets but only for a short time.

To Summarize

Using the power of compounding in your business doesn’t necessarily mean putting your money in a bank account.  It’s more on mitigating the compounding costs and maximizing the compounding returns in your business. Remember that assets or liabilities can easily add up. Every decision and step you make can either help or hurt your business performance. Thus, don’t take the power of compounding for granted by any means.