Why Does The Time Value of Money Matter To My Small Business?

Tom Felgar
By Tom Felgar
Mar 2 / 449 Views

One of the most challenging things for young and small businesses is not only understanding how to manage their cash but to make it work for them to grow. If you’re proficient at providing a quality product or service to your customers and have a sound business plan, you’re likely to be faced with the question of “how do I take my business to the next level?” A great way to do that is to use the time value of money to your benefit.

So, what is the time value of money?

The time value of money is the principle that money in your possession today is worth more than the same amount in at a later time due to its ability to generate additional funds. This concept is the basis for most retirement planning advice. The sooner a person invests their money, the more time that money has to work and accumulate interest. This process is commonly referred to as compounding.

But, compounding isn’t just relevant to a 401(k), compounding can have an extraordinary impact on your business. By reinvesting some of your business’ cash into enhancements that grow your company, you are unlocking the potential of compound interest.

Sound interesting?  Let’s take a closer look.

How does the time value of money work?

There’s a daunting formula for it (pictured).  The basic components of the formula are as follows:

Time-value-of-money-formula

The formula looks at the cash you are investing in and multiplies it by the interest rate.  It takes into account the number of times you compound interest per year, and how many years you’ll be compounding that interest. The longer the duration of compounding, the more your present dollars will be worth in the future.

And, while it’s essential to have a basic understanding of what factors impact the growth of your money over time, it’s not recommended to break out the graphing calculator to work through the equation.  Instead, use a reliable calculator, like the one offered by NerdWallet, to get the right numbers in a matter of seconds.

Let’s look at a simple example of compound interest at work.

Using Beacon Funding’s resident fictitious example character, Charlie Lease-to-Own, we can observe the power of compounding.

At the end of the year, Charlie’s startup small business generated $15,000 in profit after paying all salaries and expenses. They intend to run this small business for the next 30 years until the age of retirement. Charlie considers two options:

  • Option 1: Reinvest all $15,000 into growing the company.
  • Option 2: Take out $10,000 as an end-of-year performance bonus and reinvest $5,000 into the company.

Charlie also believes that by reinvesting in certain business activities, they can reasonably earn 10% interest annually on their investment.

So how do the numbers play out?

With option 1, the interest Charlie perpetually receives off that initial $15,000 turns into $261,742 after 30 years, assuming they earn 10% on it each year and can continue making strategic decisions to grow their business!

Compound-Interest

With option 2, the interest Charlie perpetually receives off the $5,000 invested becomes $87,248 in 30 years under the same conditions.

There are a variety of unknown variables that could help Charlie’s business grow more or go in the other direction; but, the contrast is significant. In this simplified example, the $10,000 bonus Charlie took out in the infancy stages of the business ended up costing Charlie’s company $174,494!

How can equipment financing help my business reap the rewards of the time value of money?

If you’re a small business owner and are looking to acquire a new or used piece of equipment, you probably have options. One option might be that you have enough cash-on-hand to cover the cost of the machine or are planning to save to pay cash. Or, you might be looking at financing the equipment through a specialty lender.

While there are pros and cons to both options, paying cash for a substantial piece of equipment could hamper your business’ ability to invest in other strategic upgrades or to cover emergencies. Utilizing equipment financing could give your company the flexibility to use that cash for capital investments in sales, marketing, staffing, and other areas of your business that can provide the conditions for growth.

Equipment financing also expands the pot of funds from which you’re withdrawing.

Below is a video that details how, when paired with the proper utilization of compounding interest, equipment financing can help businesses reap the rewards of strategic financial management.

Spoiler Alert: Lane Lessee decided to use equipment financing to finance a new piece of equipment and invested the cash into activities to grow their business. The result – even after paying the financing costs on the equipment, Lane netted over $60,000 in profit in just four years!

How can I invest my business’ cash to maximize the power of compounding?

Investing your liquid assets should be well-thought-out and be in line with your business plan. Consider the following questions before you allocate your funds:

  1. Where are my business’s most significant areas of opportunity for growth?
  2. What are a couple of quick wins that require modest cash investment?
  3. How will I track the efficacy of my investment, and what are my benchmarks?
  4. Am I comfortable with the rate of growth, and is my business capable of scaling up at this time?
  5. Do I have an emergency fund to pay for unexpected expenses while I am growing my business?

No two businesses are identical, and there is no cookie-cutter answer for how you should invest your funds in maximizing your business’ profits.  However, a few examples of things companies commonly invest in to grow to include:

  1. Enhancements to property, plant, and equipment (PP&E). Obtaining and maintaining the right PP&E for your business can set you up for success and be a solid foundation for growth.
  2. Marketing. Whether you are investing in digital marketing or tradition, direct response marketing, getting your brand in front of potential customers is essential to success.
  3. Sales. If your business could benefit from the use of a sales force (and most can), the right sales team can provide a springboard for your business to grow.
  4. Training. Equipping yourself and your team with continuing education will help keep your organization on the cutting-edge, increase your efficiency, and help you avoid high turnover costs.
  5. Staffing. Whether you are looking to hire more in-house talent or outsource non-core functions, strategically growing your workforce can open your business to a world of opportunity.

What’s the next step?

There’s no judgment for the $5 latte that you may or may not be sipping while reading this. The best part of understanding the time value of money is that you’re in the driver’s seat to make decisions that will help you personally and as a business owner. The point isn’t to hoard as many pennies as possible, but over the long-term to make sensible decisions with cash-on-hand to make consistent, strategic investment decisions to improve the financial performance of your business. For businesses with needs for new equipment, it may make sense to work with a trusted equipment financing company as part of their overall growth strategy.   

  •  business growth 
  •  business tips 
  •  cash flow 
  •  small business 
  •  time value of money 

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