• Invest
    Investment Suite
    Stocks
    Mutual Funds
    Future and Options
    IPO
    Exchange Traded Funds
    Commodity
    Stockcase (Stock Baskets)
    Currency
    Non Convertible Debentures
    Sovereign Gold Bond
    Exclusive
    NRI Account
    Private Client Group
    Features
    SipIt
    MTF
    Investment Suite
    Exclusive
    Features
  • Platform
    Product Suite
    Kotak Neo App & Web
    Nest Trading Terminal
    NEO Trade APIs
    Features and Tools
    MTF
    Securities Accepted as Collateral
    Margin Requirements
    Payoff Analyzer
    Calculators
    SIP Calculator
    Lumpsum Calculator
    Brokerage Calculator
    Margin Calculator
    MTF Calculator
    All Calculators
    Product Suite
    Features and Tools
    Calculators
  • Pricing
  • Research
    Research Calls
    Long Term calls
    Short Term calls
    Intraday calls
    Derivatives calls
    Pick of the week
    Top Monthly Picks
    Research Reports
    Fundamental Research Report
    Technical Research Report
    Derivative Research Report
    Research Calls
    Research Reports
  • Market
    Stocks
    Market Movers
    Large Cap
    Mid Cap
    Small Cap
    Indices
    Nifty 50
    Bank Nifty
    FinNifty
    Nifty Midcap India
    VIX
    All Indian Indices
    Mutual Funds
    SBI Mutual Funds
    HDFC Mutual Funds
    Axis Mutual Funds
    ICICI Prudential Mutual Funds
    Nippon India Mutual Funds
    All AMC's
    IPO
    Upcoming IPO
    Current IPO
    Closed IPO
    Recently Listed IPO
    Stocks
    Indices
    Mutual Funds
    IPO
  • Learn
    Resource
    Market Ready
    Kotak Insights
    Infographic
    Podcast
    Webinars
    Youtube Channel
    Quarterly Results
    Investing Guide
    Demat Account
    Trading Account
    Share Market
    Intraday Trading
    IPO
    Mutual Funds
    Commodities
    Currency
    Futures & Options
    Derivatives
    Margin Trading
    Events
    Budget 2024
    Muhurat Trading
    Share Market Holiday
    Market Outlook 2024
    Resource
    Investing Guide
    Events
  • Partner
    Business Associates
    Fund Expert
    Kotak Connect Plus
    Startup connect
  • Support
    FAQs
    Circulars
    Bulletins
    Contact Us
    Forms Download
    Get your Statement
​

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

  •  4 min read
  • 0•
  • 02 Oct 2023
What Is a Sinking Fund? Definition, Meaning, and Types Explained

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.

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.

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.

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 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.

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.

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.

FAQs on Sinking Funds

Common uses are to redeem bonds, loans, and preferred shares. But they can also be used for capital projects, equipment replacement, dividends, acquisitions.

Usually very conservative investments like money markets, short-term government bonds, and fixed deposits to preserve capital.

Typically the finance department oversees planning and contributing per schedule. Fund assets are managed by the treasury department or even outsourced.

Any surplus left can be transferred to general funds. The company may also choose to extend the fund for future obligations.

Based on the expected outflow, the tenure, and target minimum contributions required.

Did you enjoy this article?

0 people liked this article.

What could we have done to make this article better?

Enjoy Zero brokerage on ALL Intraday Trades
+91 -

personImage
Enjoy Zero brokerage on ALL Intraday Trades
+91 -