Sinking Fund Method
Categories: Accounting
You buy a shiny, brand-new car. But, being a worrywart, you can't really enjoy it. You’re already thinking ahead a decade or so to the time when you’ll need to buy another car to replace this one. "Everything ends," you say to yourself, "everything dies."
Besides being a real pill to hang out with, you do have a point. The car is a depreciating asset. Simply by driving it around, you’re wearing it out, leading to a time when you’ll have to buy a new one. Eventually, you’ll have to fork over a big pile of cash to get a new one.
Well, for you planning types, there’s a thing called a sinking fund. It's a way of saving to buy a replacement for a depreciating asset. As the asset (like the car) decreases in value over time (an accounting process known as depreciation), you invest a matching amount of cash. So...if your accountant says that, this year, your car depreciated $2,000, you put $2,000 into a sinking fund. The money generates interest until, a few years down the road, you use the cash to pay for a new car.
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Finance: What is a sinking fund?8 Views
And finance allah shmoop what is ah sinking fund oh
that oil rig she's sinking we'll meet nessie lovely pink
rig who has been working nicely for eight years now
she pumps ten thousand barrels of oil from five thousand
feet underwater without complaining a lick The experts believe that
there are literally millions of barrels below where she drills
and they know that sadly nessie won't be alive long
enough to pump all of them out from you know
below the ocean well she'll live twenty years and that's
it then she'll kill over like your favorite dog one
day and die and the company knows that they'll have
to spend a billion dollars that day toe by nesi
to the to z Well with that eventual sad day
in mind mega glop corporation crown danish oyster which owns
nessie has expected the billion dollar bill to come to
them at that time And thus far each year for
eight years they have socked away money in what is
called a sinking fund and you know it took us
a while to get there too so sorry so that
twelve years from now when the billion dollar bill comes
due it's not a big shock to the company They
will already have saved their pennies Lots of them so
that the billion box will be on hand Just sitting
in their bank of america account our bank of wherever
account ready teo Wire into riggs Are us to deliver
a brand spanking new nessie too When nesic one has
you know sucked her last oil So here's the mao
A billion dollar bill is coming due in twenty years
We have tons of advanced notice and sock away money
to pay for it on a straight line basis while
we sock away fifty million bucks a year They put
it in a mattress in you know bank of america
totally ready to go When you know her time comes
in real life The company would have lots of other
options Like buying the nessie too With leverage they could
put a fraction of the total amount of purchase her
down and maybe that's a third or less in total
price Then they could borrow the remainder amount of money
and buy the rig on credit Well they could also
just lease it from the manufacturer but then leasing it
Means that someone else owns nessie too and they maintain
it There's a lot more risk in managing it and
fixing it should nessie to ever need a trip to
the shop And things can get ugly Yeah like that
Okay Option three sinking fund buy with cash on hand
Well so why would the company have struggled so much
to put away fifty million year for two decades Well
when it comes time to negotiate with vendors about buying
a rig when the buyer is loaded and ready with
ash well then it can command much better deal terms
and probably a better price right it khun goto many
ven doors of rigs and say i got cash You've
got the rig A vendor who needs to borrow money
from a bank first teo then pay another vendor And
at worst it would have to you know borrow money
from the vendor selling the rig and they charge a
super high interest rate Ever buy a car Yeah You
don't wanna have to borrow money from a car salesman
Ever Well sinking funds essentially sink the liability of an
eventual big fat harry bill that's coming D'oh Yeah different 00:03:11.968 --> [endTime] Bill what