A sinking fund is basically a type of fund in which a certain amount of money is set aside or saved. This saved amount can later on be used for the purpose of repaying the debt.
Understanding the concept of sinking funds
The main purpose of the sinking fund is to cover up for the repaying of debts. It is necessary for any company to establish the sinking funds so that they can contribute to the fund in the further years to come when the bond gets matured. Generally a company that has been issuing debts will at one point of time have to pay off those debts in the coming future and this is where the sinking funds come into play. Here the sinking funds will help in softening the hardships of any particular revenue having a large outlay. For the sinking funds, basically the owner will start by setting aside a certain sum of money on a regular basis and then will make use of it for a specific purpose where they will need a large amount of money. Most of the time, the corporations use the sinking funds for the deposit money or the bonds so that the issued bonds could be bought back before the final date of maturity of the bond arrives. This is a great way to attract the investors because with the help of funds, it becomes easier to convince them that there will not be any default by the issuer on their payments.
So, in general, the sinking funds are created to pay off a debt in a much more convenient manner. It is also necessary as it helps to insure the fact that all possible cases of default have been removed, since now there will be sufficient amount of money for the purpose of repaying of debts. Now, in majority of the cases, it has been found that most of the bonds will take years before their maturity period finally arrives, so it is always thought to be easier if one is able to reduce the main principal amount way before it actually happens to mature. This in turn will lead to lower credit risk.
What are the various advantages of the sinking fund?
It helps in attracting the investors
Investors would never want to invest in a company that has a large number of debts because then it is likely to be at potential risks. But if the company has an already established sinking fund, then the investors feel a certain level of protection in case of bankruptcy or default.
It stabilizes the finances
There is no doubt that the sinking funds help in stabilizing finances. Now the economy keeps on fluctuating and there is always a possibility of certain unpredictable financial issues. But thanks to the sinking funds, it is ensured that you will be financially stable even during the difficult times.
Therefore, establishing a sinking fund for any company is a great financial decision as it ensures protection against any inevitable financial crisis and also attracts the investors.