Sinking Fund

A sinking fund, in simple terms, is the money set aside to pay off a debt. Investing comes with its own set of risks, and one of the biggest is the risk of default. To mitigate this risk, many bond issuers establish a sinking fund. This blog explores everything about a sinking fund.

What is Sinking Fund?

Bond issuers set up sinking funds in accounting to ensure sufficient funds available to pay off the bonds at maturity. The issuer of a bond will typically make regular contributions to the sinking fund over the life of the bond. 

These contributions are invested in a low-risk investment, such as government securities or high-quality corporate bonds, to generate a sufficient return to cover the cost of paying off the bonds when they come due. The sinking fund method reduces the risk of default for bondholders, as it ensures that sufficient money available to repay the principal amount of the bond when it matures.

The sinking fund formula is as follows. 

A = P * ((1 + r/n)^(t/n) - 1)/(r/n)

Where, A – Money accumulated
P – Periodic contribution,
r – Interest rate
t – Number of years
n – Number of payments per year

Accounting for a sinking fund

According to the Companies Act 2013, every company that issues debentures must establish a Debenture Redemption Reserve (DRR) or a sinking fund to ensure the repayment of the debentures at maturity. The DRR or sinking fund should be created before the issuing debentures and maintained until the debentures are fully redeemed.

A sinking fund is classified as a non-current or long-term asset and is sometimes included in the list of long-term investments or other investments in a balance sheet. Companies requiring significant capital to purchase new plants and equipment issue long-term debts and bonds. 
 

A real-world example of a sinking fund

Now that you know the sinking fund meaning, let’s understand it with a real-world example. 

For instance, consider company ABC Ltd., which issued ₹200 crores in long-term debt in the form of bonds, paid semi-annually. The company set up a sinking fund whereby they had to contribute ₹40 crores to that fund at the end of each financial year. By the second year, the company will have saved INR 80 crores. By the third year, ₹120 crores of the total ₹200 crores debt.

If they didn’t have this fund, they would have had to pay out the entire ₹200 crores at the end of the 5-year bond maturity period either from their profits, cash, or retained earnings. If ABC Ltd. had to pay back the entire debt, it would have been a significant burden, especially considering the interest payments made to the bondholders over the five years. 

Additionally, if the oil prices collapsed or the company could not arrange the necessary funds, they would not have been able to fulfil their debt obligation, which could have led to a default in payment.
 

Other types of sinking fund

In addition to sinking fund bonds, companies may establish other sinking funds. For example, some companies set equipment sinking funds, which are used to fund the replacement or upgrade of equipment. The company sets aside money each year in the equipment sinking fund, and when the equipment needs to be replaced, the company has the necessary funds available.

Another type of sinking fund is the maintenance sinking fund for ongoing maintenance and repair of company assets. By setting aside funds in a maintenance sinking fund, companies can ensure that they have the necessary resources to keep their assets in good working condition, which can help to reduce repair costs and extend the useful life of the assets.

Finally, some companies establish sinking funds for employee-benefit plans, such as pension plans or other post-employment benefits. By designating a sinking fund for employee-benefit programs, companies can ensure they have the necessary funds to fulfil their obligations to employees when they retire or leave the company. This can provide employees with greater financial security and attract and retain talented workers.
 

The reasoning for sinking funds

The primary reason behind establishing a sinking fund is to set aside money over time to meet a specific future obligation or expense. Regularly contributing to a sinking fund can reduce the risk of default, as companies can meet their debt obligations or other financial commitments. 

Additionally, a sinking fund can reduce the cost of borrowing, as investors may be willing to accept a lower yield in return for the added security the sinking fund provides. Sinking funds can help companies manage their finances more effectively, reduce risk, and improve their long-term financial health.

Advantages of sinking funds

There are several advantages to establishing a sinking fund, including the following. 

1.    Improved financial management: By setting aside money in a sinking fund, companies can better manage their finances and ensure they have the necessary funds available. This can help reduce the risk of default and can improve the company's overall financial health.

2.    Reduced risk: Sinking funds can reduce the risk of default, as companies can meet their debt obligations or other financial commitments. This can improve the company's creditworthiness and may result in lower borrowing costs.

3.    Lower borrowing costs: Investors may be willing to accept a lower yield in return for the added security provided by the sinking fund. This can reduce the cost of borrowing for the company.

4.    Greater financial flexibility: By having a sinking fund in place, companies may respond more effectively to unexpected expenses or opportunities without borrowing or selling assets.

5.    Increased investor confidence: Using a sinking fund can increase investor confidence in the company's financial stability and may make the company more attractive to investors.

Examples

The sinking fund example includes the following. 

1.    Municipal bonds: Some Indian cities have established sinking funds to support the repayment of municipal bonds. For example, the Pune Municipal Corporation has set up a sinking fund to support the compensation of its bond issuances.

2.    Infrastructure projects: In India, many infrastructure projects are financed using sinking funds. For example, the National Highways Authority of India has established a sinking fund to support the repayment of loans taken to develop national highways.

3.    Mutual funds: Some mutual funds in India may use sinking funds to meet their redemption obligations. These funds set aside money in a sinking fund to ensure the necessary liquidity to meet redemption requests.

4.    Insurance companies: Indian insurance companies may also establish sinking funds to support their long-term obligations, such as the payment of annuities. These funds are used to set aside money over time to ensure the company has the necessary funds to meet its future obligations.
 

Sinking fund vs Savings account

A sinking fund and a savings account are similar in that they both involve saving money for the future. However, the key distinction between the two is that a sinking fund is established for a specific purpose and timeframe, while a savings account can be used for any purpose.

Sinking fund vs Emergency fund

A sinking fund and an emergency fund differ in purpose, as the former is set up for a specific purpose while the latter is for unforeseen circumstances.

An emergency fund is intended to be used for unexpected events that may occur at any time. For instance, an individual may keep a portion of their savings as an emergency fund to cover expenses during a car accident or other unpredictable occurrences.

In contrast, a sinking fund is established with a particular purpose in mind and a specific timeframe. It is not intended for unforeseen circumstances but for planned expenses such as debt repayment or a capital project.
 

Conclusion

Sinking funds can be an effective financial tool for businesses and individuals alike. It provides a way to save and set aside funds for planned expenses, ultimately reducing the financial burden of large payments that may otherwise be difficult to make. 

By establishing a sinking fund, one can ensure that they are adequately prepared to meet their financial obligations while taking advantage of opportunities for growth and investment. 

There may be some alternatives to a sinking fund, such as a savings account. It is important to consider the specific purpose and timeframe of one's financial goals to determine which option is most appropriate. A sinking fund can be invaluable for achieving long-term financial stability and success.