Sinking Fund

What is a Sinking Fund?

A sinking fund is a type of fund that owners set aside to meet a specific requirement. The requirement may be paying off a loan or investment. Mostly the business which has debts in their balance sheet uses the funds to pay off the debt in the near future. This eases the burden to pay a significant sum at one time. 

The fund is built over the years up to the maturity of debts. Once bonds mature the sinking fund is used to pay the amount on maturity. This process is easier and more convenient. It reduces the principal amount into small denominations and is collected over a period of time. It not only reduces the default risk but also ensures timely payment.

A sinking fund gives the businesses an advantage to offer floating bonds. They also issue bonds with the attached feature of the sinking funds.

Let’s take an example to gain a better understanding of Sinking Funds

If, for example, a company issues Rs. 200 crore bonds for a period of 10 years to its investors in the year 2020. This means that the company shall have to pay Rs 200 crore at the end of 2030. The concerned company shall therefore create a separate account where it deposits Rs 20 crore every year. It shall yearly accumulate to become Rs 200 crore in 10 years. This saves the company the hassle of collecting the lump sum of Rs 200 crore in that particular time.

What is a Consolidated Sinking Fund?

Consolidate Sinking Fund is the reserve fund created for the amortization of debts. This is the fund that is available to the State Governments for meeting their liabilities. The Consolidated Sinking Fund was established in 1999-2000 by the Reserves Bank of India. It was established to meet the redemption of market loans of the states. There were several states which started the set up of sinking funds namely, West Bengal, Uttaranchal, Tripura, Meghalaya, Mizoram, Goa, Assam, Maharashtra, Andhra Pradesh, Chhattisgarh and Arunachal Pradesh. The fund is maintained as a public account. 

The fund is used wholly for the purpose of redemption of the loans which the states have taken. Each year states contribute at least 1-3% of outstanding market loans into the fund. 

What is the Sinking Fund Formula?

A sinking fund is said to work the same as depreciating an asset. A sinking fund is also established through the process of depreciation. A deprecation is incurred to match the amount of cash invested. Companies may use the two methods of depreciation for sinking funds which are the Straight-line method and declining balance depreciation techniques.

The method varies from company to company based on various factors. 

Sinking funds adds to the protection of the company by reducing the principal outlay to be paid at the end of a period. Investors gain confidence if there is a provision of the sinking fund. 

Here is an easy formula derived to calculate the sinking fund

Sinking Fund = P x ( 1+r/n) ^ t x n – 1/r÷n

Here,

P = Periodic Contribution

r = Interest Rate

t = Number of Years

n = Number of payments per year

This formula can be alternatively used to calculate periodic payments which need to be deposited into the sinking funds

P =  A/1+r/n ^ (t X n) -1/R÷n

Here,

P = Periodic Contribution

r = Interest Rate

t = Number of Years

n = Number of payments per year

Now, 

Let’s incorporate the formula in the calculation

Example

Consider a food retail company that is doing well in its business, and to expand its business operations, they want to raise money through the debt route. So that is why they have issued Rs. 50,000 worth of bonds, which matures in 10 years and has a sinking fund provision.

Solution

Conclusion

Sinking Funds is of great relevance to companies as well as investors. The likelihood of default becomes low which is beneficial for both company and investor. The provision of Sinking Funds enables the companies to create a secondary market for liquid bonds.