When you’re running a business, you must prepare for the unexpected. While having a savings account is a good start, it’s best to save that for true emergencies. Instead, you should consider establishing a separate sinking fund to pay for those costs that you know are coming but may sneak up on you.
A sinking fund is a unique kind of savings account that can help you better control your finances and avoid going into debt to cover unexpected expenses. To help you prepare, here is a full breakdown of sinking funds and how to create one.
Sinking Fund Definition
A sinking fund is a special type of savings account designed to pay for future expenses. It’s financed by the money you set aside in your monthly budget to cover expenses that will be due at some point in the future, although you may not know precisely when.
Starting a sinking fund allows you to save money over time and cover larger expenses when they come up, without interrupting your normal spending habits or digging into your existing savings.
What Is The Purpose Of A Sinking Fund?
The purpose of a sinking fund is to finance large expenditures without having to tap into your savings or go into debt. Although anyone can benefit from a sinking fund, they are essential if you run a business.
All businesses have recurring expenses that are factored into their monthly budget. Then, there are those infrequent expenses that may be difficult to predict until they need to be paid. Establishing a sinking fund is a way to set aside money from your monthly revenue to prepare for these unexpected future expenses without scrambling when the bill comes.
Benefits Of A Sinking Fund
1. Easier for Budgeting
Some expenses are easy to predict and budget for on a monthly basis, and others can be a bit more difficult to anticipate. Sinking funds give you the peace of mind of knowing that you are planning for those more volatile expenses by factoring the costs into your regular budget. That way, you don’t have to disrupt your normal spending habits when unexpected expenses are due.
2. Avoid High-Interest Debt
Another reason to set up a sinking fund is to avoid going into debt. Many business owners make the mistake of failing to adequately plan for expenses they don’t have to pay on a recurring basis. Then, when they suddenly get a bill, they may have to scramble to figure out how to pay it.
If they don’t have enough savings or can’t tap into their emergency fund, the only option may be to take out a loan. However, that loan may come with a high interest rate if the fund are needed quickly. In that case, setting up a sinking fund to prepare will be less far expensive in the long run.
3. Target Your Savings
The creation of a sinking fund allows you to earmark your savings for a specific purpose. Some savings accounts may have penalties for early withdrawal, or you may miss out on accrued interest yielded from those funds.
Creating a sinking fund that is specifically intended to be used on certain expenses allows you to separate those funds from the rest of your savings and find an account that makes the most sense for that purpose.
4. Keep Your Emergency Fund In-Tact
You don’t want to get in the habit of depleting your regular savings on routine expenses. If you’re constantly tapping into your savings to pay operating expenses, you may run out of cash if you ever face a true emergency. Creating a sinking fund allows you to establish a separation from your short-term and long-term savings goals.
Sinking Fund vs Emergency Fund - What's The Difference?
| Sinking Fund | Emergency Fund |
|---|---|
| Designed For Future Bills That You Expect | Designed To Cover Emergency Expenses |
| Used Frequently | Funds Rarely Get Used |
| Regularly Depleted | A Set Amount That You 'Park' Until Required |
| More Useful For Managing Business Costs | Only Useful When Financial Disaster Strikes |
It’s also important to distinguish between sinking funds and emergency funds. Although they are similar, there is a key distinction that sets them apart. Emergency funds are meant to cover true emergencies and impossible-to-predict scenarios.
You may contribute to your emergency fund monthly until it reaches a certain balance, or you may simply park a large amount of cash into a savings account and keep it there until you absolutely need it.
Sinking funds are designed to pay for certain bills you know will eventually be due, although you may not know when. They are financed by payments you allocate in your monthly budget and tend to be an ongoing expense. An emergency fund tends to be much more static and is intended to be used only once in a blue moon. Sinking funds may be regularly depleted and then rebuilt on a routine basis as you may pay off expenses and continue to put money away.
How Much Should You Set Aside For A Sinking Fund?
The exact amount you’ll want to save will depend on your expenses and how much income you have left after covering your normal monthly budget. However, a good rule of thumb is to take the total amount you plan to spend and divide it by the amount of time you estimate it will take before the expense is due.
Say you need $6,000 to cover the expenses that will be due at the end of the year. Then, if you start saving in January, you should set aside about $500 per month.
Sinking Fund Example
Here is an example to illustrate the difference between sinking funds and an emergency fund. Say you’re a real estate investor who owns a rental property worth $600,000. You know that it’s inevitable that you’ll need to pay for routine repairs to keep the property in livable condition. However, the exact cost of the repairs and when they’ll need to be paid can vary depending on a range of factors.
Most experts recommend setting aside about 1-2% of the property value yearly to finance routine maintenance. In this scenario, you should save about $6,000 to $12,000 per year in a sinking fund by setting aside $500 to $1000 from the monthly rent payments. That way, you can save your emergency fund for events that are more difficult to predict. For instance, if there is a natural disaster or your tenant suddenly stops paying rent.
Should You Start A Sinking Fund For Your Business?
Most businesses would be wise to create some sort of sinking fund. While it can vary depending on who you are and what you do, sinking funds can come in handy in so many different scenarios. It also makes it much easier to run your finances on auto-pilot, so you don’t have to stress when you get an unexpected bill.
There is very little downside to creating a sinking fund because you can always use the money for something else if the expenses are less than you anticipated. Plus, there are plenty of high-yield savings account options out there that allow you to earn interest while you save.
That being said, not all businesses have the same need for a sinking fund. If you don’t encounter many unexpected expenses and would rather use the extra cash flow to cover more pressing costs, then it may not be worth it. However, most businesses will benefit from establishing some kind of sinking fund to prepare for future expenses.