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What is a Sinking Fund?

There are a lot of tools out there to help you save money. They teach you about how to set up your savings accounts and where to set up your savings to get the best returns. You should study them as much as possible as they could mean the difference between healthy personal finance and a poor one.

However, life is quite complicated, and sometimes we have to borrow to meet up our needs at a particular time. So, if you want to be in total control of your financial situation, you must also understand how to manage your debts and repay them conveniently as due. 

Managing debt repayment and building a creditworthy status should be everyone’s target. This is where Sinking Fund comes in. A sinking fund is a tool set up to help us meet up with our debts or other impending obligations.

In this article, we shall discuss everything you need to know about Sinking Funds. You’ll learn how to manage your finances, save intelligently, and repay your debts guilt-free and conveniently.

What is a Sinking Fund?

A sinking fund is a form of savings account that is created for the sole purpose of repaying debt. The fund owner sets aside a certain amount of money at regular intervals for a specific purpose.

Companies often use sinking funds to deposit money to be used to buy back issued bonds before the maturity date arrives. It can attract investors because the sinking fund helps convince them that the bond issuing company will not default.

In literal terms, a sinking fund is created to make paying off debt easier and gradually build up a sufficient amount of money before the maturity date arrives. For instance, most bonds take several years to mature, and it is always more convenient to start building up the principal amount long before the maturity date approaches.

It has proved to be successful towards meeting large volume obligations over the years that individuals and corporate entities have also adopted sinking funds to meet targets for big purchases in the future. E.g some individuals may set up a sinking fund to deposit a percentage of their wages towards a big vacation at the end of the year.

How Does a Sinking Fund Work?

Suppose XYZ Corp. has issued a 10-year bond worth $50 million to investors at an interest rate of 5% per annum.

It is expected that the bond will not mature until 2031. However, instead of waiting till 2030 or 2031 to start scampering around to raise $50 million to pay back investors, the company can decide to set up a sinking fund where they deposit a percentage of the total amount (i.e, $5 million) of their annual income. By the time the 9th year arrives, the company would have raised over 90% of the bond principal. It then becomes much easier to pay back the investors as due 2031.

Furthermore, before buying a company’s bond, Investors usually request for proof of creditworthiness. A sinking fund helps to demonstrate a lower credit risk as the years go by.

Why should you set up a Sinking Fund? 

The following are the advantages of sinking funds.

1. Attracting Investors

Investors are aware that corporations with large volume of debts carry a lot of credit risk. Establishing a sinking fund will go a long way to allay their fears. It is seen as a blanket of protection on their investments. Most importantly, in the case of bankruptcy of the company, investors will still be able to recoup a significant part of their investment.

2. Low-Interest Rates

If a company has poor credit ratings due to bad debt-management in the past, it will find it difficult to attract investors unless it offers much higher interest rates. Since a sinking fund helps to lower default risk by providing alternative protection for investors, it can help them access funds at much lower interest rates.

3. Stable finances

Companies usually operate in cycles. Likewise, the country’s macro-economic fortunes may fluctuate for different reasons. This means that the company can run into turbulent waters, often due to no fault of theirs. And this can have debilitating impacts on its earnings during a particular period. If this period coincides with maturing debt obligations, they will find themselves at serious risk of default.

However, with a sinking fund, the company can spread out the incidence of repayment over several operating cycles. Hence, its ability to meet obligations is not compromised by a little downturn in its fortunes.

This results in good credit standing and sustained confidence of investors.

Disadvantages of a Sinking Fund

  1. Liquidity Crisis: A sinking fund involves having to deposit a certain percentage of a company’s cash float from time to time. This can hugely impact the business’s liquidity and its ability to meet its running costs over time.
  2. Opportunity Cost of funds: Some experts may argue that the money stomped away in a sinking fund can be put to better use. Some experts my argue that there are better ways to invest money, such as High-Interest Savings Accounts, purchasing stocks, crypto-currency, etc. can all potentially yield better earnings over time than locking the funds away in a sinking fund.

The sinking fund is often mistaken for other forms of savings as they can have similar features. It is important to draw a line to differentiate them.

Sinking Fund vs. Savings account

In theory, there is only very little difference between a sinking fund and a regular savings account in theory. They both involve setting a sum of money aside for the future. The main distinction between them is that while the former has its purpose clearly specified, while the latter is set up for any speculative purpose that it may serve in the future. Examples of savings accounts include, RRSP, TFSA, HISA etc.

Sinking Fund vs. Emergency fund

An Emergency fund also shares striking similarities with a Sinking Fund.

However, whereas a sinking fund is purposely established for something definite and at a pre-determined date, an Emergency fund, on the other hand, is for something whose occurrence is uncertain or unexpected.

In simpler terms, an emergency fund is set aside for uncertain events but can happen anytime. It serves as insurance against the occurrence of incidents that cause significant loss.

For instance, an emergency fund may be spent on a car accident, key equipment failure or other risks that cannot be predicted. An emergency fund helps an organization stay prepared to fund an incidence of huge losses or significant operational failures that can negatively impact their day-to-day running. It is seen as an alternative to huge insurance premium payments.

Conversely, a Sinking fund is set up towards repayment of a finite debt that has a definite (expected) date of maturity.

Final thoughts

A sinking fund is very easy to understand and set up. However, many people fail to create one because they lack the financial discipline to set aside funds regularly ahead of their maturing obligations.

Every borrowing corporate entity or individual should have one. You can liken it to doing your college homework in bits way before the submission deadline arrives.

It helps if you repay your obligations without the pressure of deadlines. A good credit standing is always beneficial and can be very crucial to your survival in the long-run

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