What is Sinking Funds? Its Meaning & Types

Sinking Funds Meaning

Funds set aside by a company to redeem debt or bond redemption. The company makes periodic contributions to the fund to accumulate enough to pay off the obligations. Other usage of sinking funds can be future purchase of machinery, assets, real estate or the cost for expanding the business.

Why have Sinking Funds?

To plan for an eventual redemption of debt/shares and smooth out the cash flow impact for a company rather than a large lump sum payment. This provides financial stability to a company.

Who Manages them?

The sinking funds for a company are usually financial officers within the company manage and oversee the sinking funds per an established schedule and investment policy. Any Companies can establish sinking funds for preferred stocks, bonds, debentures, loans or other debt with a maturity date. This allows orderly retirement of obligations.

One of the major drawbacks of sinking funds is that it ties up capital that could be used for other purposes. Opportunity cost of investing in low return liquid assets rather than higher return opportunities.

Types of Sinking Funds

Some of the types of sinking funds is as follows:

• Callable bonds: Callable bonds refer to the portion of xyz company bonds that need the company to pay off a portion using the sinking bonds.

• Debenture Redemption Fund: Companies raise funds through debentures, which are long-term debt instruments. SEBI mandates companies to create these funds to redeem debentures on maturity.

• Preference Shares Redemption Fund: Companies that issue redeemable preference shares must set aside funds annually to buy back these shares on the redemption date.

• Loan Repayment Fund: When taking large business loans, firms may set up sinking funds and make installment payments into this fund to repay the principal amount on maturity.

• Capital Expenditure Fund: Some capital projects like factory expansion may take 2-3 years. Companies contribute over this period to accumulate funds for large expenses rather than taking loans.

• Equipment Replacement Fund: To plan for periodic replacement of machinery, vehicles, computers etc. without disrupting operations and finances.

• Business Acquisition Fund: This funds helps to save up to have sufficient liquidity to capitalize on merger and acquisition opportunities when they arise.

• Dividend Equalization Fund: To smoothen dividend payments, companies set aside profits in good years to maintain dividends in lean years.

The goal of all these sinking funds is prudent financial planning to meet known future obligations, avoid disruptions, and utilize opportunities.

Real-World Example of Sinking Funds

As you know what a sinking fund is, Now let's know one example to clear the understanding of it. Consider a company named XYZ LTD, in need of cash, issues a bond worth ₹400 crores in a long term bond for the time period of 5 years. According to this bond, the company will set up a sinking fund which will be contributing an amount of ₹80 crores annually. Same amount will be collected in the sinking funds for the 2nd year. And considering the tenure of bonds, the company will be clearing its debt in the next 5 years of tenure.

And in case if the company cannot collect the required amount annually, then it has to pay the entire ₹400 crores at the end of the 5-year bond maturity period. And due to some factors if the company is not able to collect the required funds then it would be a default in payment.

Advantage of Sinking Funds

Some of the major benefits of Sinking Funds is as follows:

• Company Gets Financial stability: Regular contributions to the funds help ensure there is money available to redeem debt and equity on schedule without straining finances.

• Smooth Cash Flow Management: Setting aside incremental amounts smooths out large lump sum debt repayments. This steadies cash flow.

• Reduces Financial Risk: With the funds already saved up, companies lower the risk of defaulting on obligations or being forced into new debt.

• Minimum Debt: Internally built up sinking funds mean companies can borrow less from external sources. This lowers interest costs.

• Investing flexibility: The liquid assets accumulated can be invested based on interest rates and market conditions to optimize returns.

• Tax Optimization: Contributions to some sinking funds can get tax advantages compared to setting aside profits after tax.

• Signaling stability: Well-funded sinking funds indicate financial prudence and stability to investors, credit rating agencies and lenders.

• Shareholder confidence: Systematic share repurchases or dividend payments via sinking funds reassure shareholders.

Conclusion

The sinking funds provide an effective tool for stability. By systematically setting aside resources over time, companies can accumulate the necessary funds to cover major expenses as they arise. Though it requires financial discipline, contributing to thoughtfully crafted sinking funds allows managers to operate from a position of strength rather than weakness when obligations or prospects emerge. Implemented wisely, corporate sinking funds form the bedrock for stability and success in both the short and long-term.

In short, this highlights proactive financial planning, provides flexibility for companies to capture opportunities, reduce risk, steady cash flows, and ultimately strengthen stability and operations over the long run.