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.
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.
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.