What Is a Sinking Fund? Definition, Meaning, and Types Explained

What Is a Sinking Fund? It’s Meaning & Types

A sinking fund is a special-purpose fund created by setting aside money over time to pay off a future expense or debt. Unlike a general savings account, a sinking fund is earmarked for specific goals, such as repaying a loan, replacing an asset, or funding a major purchase. Understanding the sinking funds meaning and how they work can empower individuals to meet financial obligations without undue stress. Read on to learn more about the purpose of sinking funds, compare them with savings and emergency funds, and explore potential drawbacks.

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?

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

Types of Sinking Funds

Some types of sinking funds are as follows:

• Callable bonds: Callable bonds refer to the portion of a company’s bonds that need to be paid.

• 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 instalment 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 fund helps to save up to have sufficient liquidity to capitalise 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 utilise opportunities.

Real-World Example of Sinking Funds

Now that you know what a sinking fund is, let's look at one example for a clear picture of the concept. 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,it would be a default in payment.

Sinking Funds vs Savings Account

While both sinking funds and savings accounts involve setting aside money, they serve different purposes. A savings account is typically used for general savings and can be accessed for any reason. In contrast, a sinking fund is dedicated to a specific goal or expense. This distinction helps maintain focus and discipline, as the money in a sinking fund is not easily diverted to other uses. By clearly defining the purpose of a sinking fund, companies and business owners can ensure that they are prepared for future financial needs without tapping into other savings.

Sinking Funds vs Emergency Funds - What's the Difference?

Sinking funds and emergency funds are both vital components of a sound financial strategy, but they cater to different needs. An emergency fund is designed to cover unexpected expenses,. It acts as a financial safety net, providing peace of mind during unforeseen events. On the other hand, a sinking fund is pre-planned and earmarked for anticipated expenses. While both funds require regular contributions, their distinct purposes highlight the importance of having separate allocations for emergencies and planned expenses.

Advantage of Sinking Funds

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

• 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.

• Reduced 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 optimise returns.

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

• Signalling 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.

Are There Any Disadvantages of Sinking Funds?

Despite their benefits, sinking funds may have some drawbacks. One potential disadvantage is the opportunity cost associated with tying up money in a specific fund. Funds allocated to a sinking fund may not be readily available for other opportunities, such as investments with higher returns. Additionally, managing multiple sinking funds for different goals can become complex and may require diligent tracking and organisation. It is also possible that the specific purpose of a sinking fund might change over time, necessitating adjustments in the saving strategy.

Conclusion

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.