What Are Some of the Uses of Compound Interest in Business? (2024)

Owners of small businesses often have limited sources of income and are further burdened by expenses, making it extremely difficult to contribute generous sums to saving accounts. Even in money-tight situations, you need to set a portion of your earnings aside for savings and pave a pathway to a secured future. If you want maximum returns on your savings and investments, investments that offer compound interest calculations can be viable options. Take a look at how compound interest works and see some compound interest examples in real life.

Compound Interest Formula and Example

Compound interest is one of two ways to calculate interest – the other is simple interest. While simple interest calculates interest on the initial principal only, the Corporate Finance Institute explains that compound interest lets you enjoy higher returns by paying you interest on the principal amount plus the interest you previously earned.

The compound interest formula works out to the following: A = P(1 + r/n)^nt. To break this down, P is the original amount of money, i is the interest rate, n is the number of periods interest compounds, and t is the total years for the loan or deposit. You can use a compound interest calculator or spreadsheet formula to save some time versus doing a manual calculation.

If, for example, you invested ​$1,000​ and earned ​$50​ in interest at the end of the earning period, your new principal becomes ​$1,050​. The interest rate will be applied to ​$1,050​, not to your original ​$1,000​, the next time interest is calculated.

Helps Companies Generate Profits

Compound interest opens doors to sources of profits for a company. For example, businesses can please investors by earning them higher profits than expected. Financial managers are expected to give dividends to investors. If these dividends are accumulated, or more precisely compounded, and reinvested in the business, higher dividends may be payable the next year.

According to Charles Schwab, compound interest is a means for profit growth if used wisely. It works as a return multiplier, and with each passing year, the interest that investors receive grows because they earn interest on interest.

Ensuring Pension Payments

Various companies seek assistance of investment accounts to pay pensions. Typically, employers exclude a fixed amount of their employees' salaries and contribute it to their pension fund. The amount accumulates for years until the employees reach retirement age, when the entire amount is provided as pension.

Businesses use the money in pension funds to invest in financial instruments that pay guaranteed return rates. This helps to generate a smooth cycle of pension payments, while earning consistent returns on the investment saved for so many years. The retirement trust fund maintains its core essence of timely pension payment to its retired employees, a process that is effectively enhanced by the concept of compound interest.

Compound Interest Pros and Cons

When looking at some compound interest examples in real life, you'll see that the idea of compound interest is appealing only when you are on the earning side of the financial balance. Banks typically pay compounded interest on deposits. So, this benefits you if you're depositing money.

On the other hand, if you are a credit card holder, knowledge of the workings of compound interest calculations may be incentive to pay off your balances quickly. Credit card companies charge interest on the principal amount and the accumulated interest. If you prolong paying off your credit card debt, your principal will grow, because compound interest calculations reset your initial principal to include previously earned interest.

The benefit of compound interest is dependent on your financial perspective. If you are a borrower, compound interest calculations translate to growth in the amount you owe and the lender reaps the benefit. If you are the investor, you reap the benefit as your money grows.

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