Meaning of Sinking Fund
Sinking fund refers to fund containing money that is set aside by business organization for paying off debt at the time of maturity or funding capital expense in future. The fund is created by owner where fixed amount of money is kept aside on regular basis and is used only for specified purpose. This way the fund gets accumulated over a period of time through small regular contributions and help companies in meeting huge expenses strategically. Sinking fund can be basically called method of saving money by keeping aside little bit amount every month. It therefore assists organizations in easing the burden of significant revenue outlay.
Every company that issues long-term debts need to repay the borrowed amount timely at maturity for winning the market confidence. Repayment of borrowed capital requires large lump-sum payment, thereby resulting in significant outflow of company revenue. Sinking fund avoids business from such situations by gradually saving small amount on regular basis and utilizing the same for debt and bond repayment. This way debts are paid off easily without having any large impact on company’s funds. Investors also feel safe to invest in companies having sinking fund as they get protection against risk of default on their money.
Types of Sink Fund
Various types of sinking fund are: –
- Specific purpose sinking fund- It is a fund that is set up and utilized by companies for specific purpose only and nothing else. Due to its nature of specific purpose, it is only referred to as specific purpose sinking fund.
- Purchase back sinking fund- Purchase back sinking fund is one that is utilized by companies for buying back bonds. There are two prices at which bonds can be purchased from bondholders: one is market price and another one is sinking fund price.
- Regular payment sinking fund- Regular payment sink fund is set up business organization with the motive of doing regular payments to trustee and other creditors.
- Callable bond sinking fund- A callable bond sinking fund as per its name, is one in which company has fixed call price. So, this fund is available when needed by organization.
Advantages of Sinking Fund
The advantages of sinking fund can be well-understood from points given below: –
- Attract Investors- Sinking fund helps a lot to companies in attracting investors. The investors known it clearly that it is quite risky to invest in companies having large amount of debt. Presence of sinking fund in organization offers measure of protection to creditors. Therefore, once investors get aware that company has established sinking then they get assured against risk. It is because if there is any default or bankruptcy, their investment amount will be paid back out of sinking fund by company.
- Lower interest rate- Companies with poor credit ratings need to pay higher rate of interest for bringing in investors. The payment of high interest rates has negative impacts on positive cash flow of company. Sinking fund enable companies in paying low rate of interest to investors as it enhances their creditworthiness in market. A lower interest rate means company need to incur less expense on interest payments that will result in increasing cash flow and net income. Presence of sufficient cash flow is much needed for business in order to run its operations seamlessly.
- Financial security- Establishment of sinking fund provide financial security to business enterprise through which all financial issues can be dealt with ease. The economic situation of company is not definite at all times and few financial matters may shake its stable ground. However, in presence of sinking fund, company’s ability to pay back its debt and buy bonds will not be compromised. This helps in maintaining good credit standing and give confidence to investors.
- Tax and Capital gain benefits- Internal revenue service department provide companies deductions for doing interest payments to their creditors. Deduction of taxes enhance the cash flow of business. Such tax savings can be utilized as financial leverage for funding portion of annual sinking fund payments. Another benefit of sinking fund is that it also allows companies to enjoy benefits arising out of capital gains.
Disadvantages of Sinking Fund
Various disadvantages of sinking funds are: –
- Reduce company’s profit- First disadvantage associated with maintaince of sinking fund is that it reduces the profit level of companies. A certain amount out of revenue is kept aside on regular basis in separate account and this amount can’t be used for funding growth activities or payment of dividends. This way sinking fund obstructs the profit earned by company.
- Difficulty- Another limitation is difficulty in proper estimation of asset valuation that needs to replaced in future using the amount accumulated in sinking fund. Sinking funds are many times created by companies for replacing heavy capital asset in future involving huge cost. If there is no proper cost estimation of specific asset then it will result in creating a lot of confusion.
- Uncertainty for investors- Sinking fund also results in bringing uncertainty for investors. Available of sinking fund facilitates the early redemption of debt and bonds for companies, thereby reducing the time period for which investors can enjoy interest payments. Investors are unable to make greater profit out of their investment, if company goes for early buy back of its debt securities.