Sinking Fund - Meaning, Types, Advantages & Formula

Sinking Funds: Meaning, types, and how to start one

Funds that are accumulated on a periodic basis to be used for specific purposes or unexpected expenses are Sinking Funds. Read on to know more about it.

Your go-to guide to Sinking Funds

There are many tools or methods that help you manage your money. Using these, you can probably manage your finances more effectively. However, putting finances in order is one thing, but you also need to learn the best way to save money. If you wish to be smart about your savings and enjoy the fruit of your hard work, you need something more than just a savings account. Here comes Sinking Fund to your rescue. Read on to know the sinking fund meaning and other details.

What is a sinking fund?

Sinking funds are funds set aside on a monthly, quarterly, or yearly basis for debt repayment or bond redemption. In simpler words, a sinking fund is funds accumulated on a regular basis towards a predetermined expense. Let’s say, a company issues bonds, it will need to pay off this debt in the future. In such a case, the company will establish a sinking fund by contributing to the funds for years leading up to maturity to pay off the debt and reduce the burden of disbursing a lumpsum amount at maturity. Apart from bonds, sinking funds can be created for future capital purchases such as machinery, real estate, and other fixed assets or any other huge expense in the foreseeable future.

Real world example of a sinking fund

Let’s understand this with an example. Say, XYZ Co. issued bonds worth ₹150 crores for a period of 5 years. The company decided to set up a sinking fund wherein they will contribute ₹30 crores at the end of each financial year. This way, by the end of 5 years, they will have ₹150 crores in sinking funds which they can use to repay their debt. What if ABC Co. had not set up a sinking fund? Then they would have to pay out ensure ₹150 crores at the end of 5 years to all the bondholders from their profits, cash, or any other mode as they deem fit. Now, it is for you to understand whether sinking funds are helpful or not for a company to meet its expenses.

Accounting for a Sinking Fund

A sinking fund is recorded in the company’s balance sheet as a non-current asset or a long-term asset. It is often classified under the heading of long-term investments or other investments. This practice is widely prominent in capital-intensive enterprises where long-term debts or bonds are issued for acquiring new plants and equipment. The sinking fund serves as a financial cushion, thereby ensuring that enough funds are available for the repayment of debt over time.

Types of sinking funds

After learning what sinking funds are, it is time for you to understand various types of sinking funds.

Callable Bond Sinking Fund
A fund maintained for calling the bond issued by the company at a fixed call price is called Callable Bond Sinking Fund.
Specific Purpose Sinking Fund
When a company creates a fund for a specific purpose, say, to buy particular machinery, it is called a Specific Purpose Sinking Fund.
Regular Payment Sinking Fund
This fund is created to make recurring payments like payments to trustees or interest to bondholders.
Purchase Back Sinking Fund
When a company wants to purchase a bond back, it can create a Purchase Back Sinking Fund. A bond can be repurchased at either the market price or a sinking fund price.

Advantages of creating a sinking fund

Below are a few ways in which a sinking fund helps a company:

To pay its liability in advance by contributing it to the fund
To clear its debt on time as the money has already been kept aside
To redeem the bond/liability in the mid, if required
To increase the faith and trust among investors as all the debts are paid on time

How to calculate the amount to be contributed to a sinking fund?

Below is the sinking fund formula used to calculate the amount of contribution. Contribution = Money to Accumulate * [Interest / (Interest + 1)^{(Compound Frequency * Period)} – 1] In the above sinking fund formula, a. The ‘Money to Accumulate’ refers to the lump sum amount you need on maturity b. The interest here is the annual compound interest rate that the company receives c. Compound Frequency is the number of times interest is paid in a specific period d. Period here is the number of years for which contribution needs to be made You can also use the sinking funds calculator to know the amount of contribution you need to make to receive a lump sum amount on maturity.

Conclusion

A sinking fund is the money regularly contributed to meet a specific purpose like repaying a debt, buying an asset, or for unforeseen expenses. It is very easy to create and understand sinking funds. However, many companies fail to create one due to a lack of awareness of its benefits, or they fail to contribute funds regularly. If you have created a sinking fund for your company, please know that it takes time and patience to achieve your desired goal.