The Disadvantages of Sinking Fund

Companies use sinking funds to help ensure the protection of assets. By protecting assets, a sinking fund allows a company to gain credibility in the investment community. For example, investors will generally look more favorably upon a company that has set aside a reserve of cash to pay for potential future liabilities associated with assets. However, the benefit to the investor is not always positive because ultimately the company decides how to use and apply the sinking fund.

Sinking Fund Overview

A sinking fund is a reserve set aside by a business that issues stocks or bonds to help repay potential future liabilities. By having these funds set aside, a company can choose to retire shares of preferred stocks and outstanding bond issues in the future. Some types of bonds require companies to pay interest payments to the bondholders for the life of the bond before having to pay the principal.

Advantages of a Sinking Fund

One of the primary advantages of a sinking fund is it can attract investors because the shares or bonds that the company offers have the backing of a tangible fund. This type of funding helps to ensure that the company’s longevity and therefore makes the company more favorable to investors. Bonds issues that have a sinking fund, generally will demand a premium because the funds help to ensure that the company can continue to pay the bond obligations in the long term.

Disadvantage

In most cases, stocks and bonds that have sinking funds hold specific provisions that you must understand as an investor. These provisions usually allow the company to repurchase the stocks or bonds at any time for a specified price. The company will then typically wait until interest rates are at the lowest possible point before repurchasing the stocks or bonds. Investors holding the stocks or bonds will typically not benefit from this repurchase scenario.

Uncertainty and Depreciation

Even though a limit typically exists as to how many of the stocks or bonds a company can buy back, the company can repurchase the stocks or bonds at any time, resulting in a potential loss for the investor. Selling the bonds on the secondary market prior to any repurchase is one method used by investors to maximize the return on the investment. Sinking funds also have the potential to depreciate. Companies will typically invest sinking funds and this investment can also underperform because of a slow economy or the unpredictability of the market. If the funds are not managed properly, sinking funds can therefore also experience losses for the business.

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About the Author

Brian Bass has written about accountancy-related topics and accounting trends for "Account Today." He works as a senior auditor specializing in manufacturing and financial services companies for one of the Big 5 accounting firms. Bass hold a master's degree in accounting from the University of Utah.