Sinking fund – What is it, definition and concept | 2022

A sinking fund is that amount that is linked to a debt operation. In this fund the borrower periodically accumulates amounts in the form of reserves.

That is, a sinking fund is an amount of money that is linked to an acquired loan. Thus, the debtor gathers a capital that will serve as a safeguard to face the obligation.

In an everyday context, a sinking fund could refer to classic savings earmarked for a specific purpose. In other words, having €10,000 saved in general in a current account is not the same as having €1,000 saved exclusively for possible breakdowns that may occur in our home.

Therefore, extrapolated to the business environment, a sinking fund is an amount of money that the company has for certain objectives and situations.

Then, these reserves are intended to be part of the debt payment, serving, for example, as a provision in times of liquidity shortage for the borrowing entity, among other uses.

Characteristics of the sinking fund

This type of funds is frequently given when the company or entity wishes to prevent adverse future situations. Some of the most common are:

  • Liquidity shortage.
  • Interest rate hike.
  • Renegotiate in a weak position.

First of all, if the problem is a lack of liquidity, creating a fund can be counterproductive, since the room for maneuver is minimal.

Secondly, if the periodic payments of our obligations are increased in amount (due to the rise in interest rates), it will be more difficult if we want to allocate the same amount of resources to the fund. Not to mention that the fund itself will have lost value if the contributions are not increased proportionally to what the fees have risen.

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Thirdly and lastly, if we wish to renegotiate our debt because the conditions no longer fit the market, if we do not have a minimum shield (depreciation fund), the lender is the one that has the upper hand, since no other entity is going to dare to finance us if we have not been able to convince the one that financed us in the first instance.

Therefore, the creation and development of this type of initiative is a good way for a company to control its debt. However, not all of them can carry them out, since normally when they have a debt it is due to a short-term deficit or lack of savings, which greatly complicates creating a fund when the problem lies in the fact that it has not been possible to generate saving.

Sinking Fund vs Accumulated Amortization

The differences between ‘depreciation fund’ and ‘accumulated depreciation’ should be noted, as they can lead to confusion if the concepts are not well established.

On the one hand, as has been mentioned, an amortization fund is aimed at shielding the credit quality of a company.

However, on the other hand, the accumulated depreciation consists of the amount that is accumulated periodically as accounting depreciation of an asset of the company, which is usually machinery, among others. This accounting concept is based on a series of calculations that subtract value from a company asset in a systematic way so that its value, as the years go by, is as close as possible to the real or market value.

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Therefore, both terms, although similar, have nothing to do with each other.

Sinking Fund Example

In a region in the south of Spain, a company dedicated to agriculture is considering the acquisition of a piece of land recently put up for sale.

The land is adjacent and they are strategically interested in buying it, but they do not have immediate liquidity to face the operation. Therefore, the company can take two options:

  • Buy the land now, via debt.
  • Wait to obtain enough savings to face the operation without having to go into debt.

In this case, the company opts for the first option, since, although it has good cash flows, it decides not to risk another potential buyer jumping ahead.

In addition, in the face of similar future situations that may arise, the company decides to create an amortization fund so that, in the event of a similar future situation, it can decide whether it is interested or not.

In the event that the company decides to carry out another purchase operation in the future, it may either cancel part of the current debt and request a new one, or it may request an extension of the current loan and put the amortization fund as collateral. or demonstration of solidity at the credit level.

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