What is a Sinking Fund?

A specific amount is deposited in an account to save it for multiple purposes of the company in the future. This account is called Sinking Fund and it is used for reasons like replace a unproductive asset or repay a debt or buy back a bond. It is similar to the savings bank account that people use to deposit money and can be used for a set purpose.

Sinking funds, with regard to a company or business, works as a savings account for specific set purpose merely with an intention of keeping the company in a position to meet emergency expenditure.

The concept of sinking fund is also used and implemented in personal cases, where individuals plan to keep aside a specific amount periodically to meet unexpected medical expenses.

There is also something called the Emergency Funds or Contingency Funds which is similar to sinking funds except that in this case, the organisation has the liberty to use to cover a varied range of different contingencies. This list of unexpected and unconventional emergencies might also be something that were not anticipated initially during the beginning of the fund life.

What is the difference between sinking fund and savings account?

  • The first and foremost difference is that in case of sinking fund, the fund owners may use the money collected only for one specific purpose as decided initially. During the course of the sinking fund period, if the fund owners use it for some other purpose, the fund loses its purpose. In contrary to sinking fund, savings accounts are used by account owners to pool money and use it for multiple purposes, few of which they might not even know of when they opened the account.
  • Companies set a target amount that is to be collected within a specified period so as to meet a particular expense whereas savings accounts usually don’t have a deadline to collect money to meet the target.

Why should I use sinking fund?

Sinking funds and its usage is very important in a company and there quite a few reasons to do it. Sinking funds are usually set up to meet unexpected medical expenses. Even in cases of not knowing the exact amount that will be needed in the future, sinking funds can be set up.

When a sinking fund is being set up, you first need to decided the target amount and then divide by the number of months you have until the commitment. This will tell you how much you need to set aside every month from your monthly budget. This will, over time, get accumulated and be available for you at the time of the commitment.

What are the types of sinking funds?

  • Specific Purpose Sinking Fund – Under this fund, the company uses the amount accumulated over a period of time only on a specific purpose and not on anything else.
  • Callable Bond Sinking Fund – The name in itself says it all. A callable bond sinking fund is a type of fund in which the company has a particular call price.
  • Purchase Back Sinking Fund – There are times when a company will want to buy back a bond earlier than discussed and purchase back sinking fund is used to do just that. A bond can be usually bought back from the bond holders at two different prices, one at the market price and the other is at the sinking fund price.
  • Regular Payment Sinking Fund – This type of sinking funds is used to make regular payments

What are the advantages of sinking fund?

  • A company has put itself in a position where it is able to repay a debt in time because the presence of a sinking fund has assured of it.

  • A company uses the sinking fund to pay liabilities well in advance.

  • Repayment of dept in time using the sinking fund is a very good sign of progress of the company and this makes the investors satisfied and builds trust with more new investors.

  • A sinking fund is most often used to buy back or retire a bond mid-way or any other liability for that matter. For example, a sinking fund for a 10-year old bond may help the company buy back 10 % every year, thus reducing the interest rates on the payment. This reduction in interest payment will please the rest of the bondholders.

  • When a company buys back a part of a bond before its maturity date, the bonds in circulation will be lesser than before and since bond prices are a direct function of supply and demand, reduction in bond supply will automatically drive the prices up.