Sinking Funds: Definition, Types, Advantages & Disadvantages Explained
A company that issues a bond or debt has to pay off the debt at some point in the future. That’s the reason why a lot of businesses create a sinking fund – a separate fund to pay off their debt seamlessly at the time of their bond’s maturity. A company accumulates this fund periodically and keeps it in reserve.
This blog aims to educate our readers about what a sinking fund is, its types and its advantages.
What is a Sinking Fund?
A sinking fund is a fund that operates as a reserve fund to save up money exclusively to pay off debt or bonds of a debt-issuing business. Bonds issuing companies would have to pay off their debts at the time of maturity. In order to avoid lump sum payments at the time of bond maturity, companies set up a separate fund called a sinking fund.
Companies can regularly contribute to this fund to accumulate money up until the bond’s maturity, that’s sufficient to pay their liabilities or to buy back issued bonds and preferred shares before maturity.
When companies need to replace expensive assets, they employ this strategy. Companies have sinking funds to assist them in recovering the cost of assets. In addition, it helps them account for the depreciation of assets and avoid paying for the replacement of such assets one at a time.
Large-scale enterprises, like the utility sector that depend on costly long-term assets, often adopt the sinking fund strategy.
How Does Sinking Fund Work?
A sinking fund is essentially created so that corporations can contribute to the funds over a period. It enables firms that have issued debt in the form of bonds to save money gradually and avoid a hefty lump-sum payment at the time of maturity. Some bonds have a sinking fund provision linked to them.
This fund acts as an account where the company saves these funds for the future. The company immediately transfers the depreciation that is charged on these assets to sinking fund accounts.
Companies then invest the same amount in government bonds. Whatever interest these companies earn from such investments, they reinvest it in sinking funds.
What are the Types of Sinking Fund Accounts?
There are four different types of sinking fund accounts, and they are:
1. Regular Payment Fund
Companies create these funds when they need to make periodic payments to creditors, trustees and other parties. They make the regular payment fund to ensure that they have sufficient balance for these payments.
2. Buyback Fund
Large corporations can create sinking funds to repurchase a bond back from bondholders before maturity, either at the stockpile price or the market price.
3. Callable Bonds
Companies maintain this type of fund to call the bond companies issue at a fixed call price.
4. Specific Purpose Funds
This type of account is created to accumulate funds meant for a specific purpose at a certain time.
How to Calculate the Amount Required for Sinking Fund?
If you want to calculate the amount required by a sinking fund, here is the formula:
A= {(1+r/m) x n x m – 1 / (r/m)} x P
In this formula;
A stand for the money that the companies accumulate
P refers to the company’s periodic contribution to a sinking fund
R is a rate of interest
M stands for the number of payments in a year
N stands for the number of years
Furthermore, one can calculate the periodic contribution required for a sinking fund with the help of the following formula:
P = (r/m) / {(1+ r/m)^n x m – 1} x A
The value of each alphabet in this formula is the same as above.
What are the Advantages of Using Sinking Funds?
These are some of the benefits of using sinking funds:
1. Attracts Investors
Investors know that businesses or organisations with a high debt load are risky investments in general. However, once consumers are aware that such companies created sinking funds, they will see a certain level of security for themselves.
This is because they will be able to recover their investments in the event of a default or bankruptcy.
2. Maintains Financial Stability of a Business
A corporation’s financial status is not always certain, and some financial issues might cause instability. However, with a sinking fund, a company will not jeopardise its capacity to pay off debt and the buyback bonds.
As a result, investors gain confidence, and their credit standing improves.
3. Potential for Lower Interest Payment
Unless they provide higher interest rates, a company with a bad credit rating will have difficulty luring investors. A business that wants to issue bonds at a lower interest rate can create a sinking fund to provide investors with the assurance of financial stability.
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What are the Disadvantages of Using Sinking Funds?
The various disadvantages of a sinking fund are:
1. Companies may Incur Losses
Sinking funds may also lose value over time. Many companies often invest in sinking funds, and such investments can underperform due to a volatile market and slow economy. If the companies fell to manage such funds properly, it can potentially cause losses for the firm
2. Zero Benefits from a Repurchase Scenario
Most of the time, sinking fund stocks and bonds contain specific provisions important for investors to know. These clauses typically let the business repurchase the bonds or stocks at any time for a certain price.
The corporation will usually hold off on repurchasing the stocks or bonds until rates of interest are at their lowest. However, this repurchase scenario will usually not be advantageous to the investors of the company’s share or bond.
Difference between Sinking Fund and Savings Account
The only semblance that a sinking fund has with that of a savings account is that both involve storing away money for the future. The primary distinction between the two is that companies set up sinking funds to ward off lump sum payments during bond maturity.
Whereas, opening a savings account doesn’t have any specific purpose like sinking funds other than saving up a certain sum of money for future goals.
Difference between Sinking Funds and Emergency Funds
A sinking fund is not the same as an emergency fund because the former is set up for a specific purpose. It is a stockpile that needs to accumulate a certain amount of funds.
On the contrary, an emergency fund is set up to meet any unforeseen financial crisis.
Things to Know Before Creating Sinking Funds
Here are some things that you should know before creating a sinking fund for your business:
- Make a list of your sinking fund categories and the amount you want to save in each of those categories.
- Determine how many months you wish to save your money.
- You then have to divide the required amount by the number of months.
- Allocate the money into your sinking fund for each category.
Final Word
Any debt-issuing company should know the importance of having a sinking fund. Since companies having a sinking fund have a lower chance of defaulting on debt repayments, investors perpetually have a certain degree of faith in these companies.
FAQs
Ans: Suppose ABC Ltd. issued 10,000 bonds at Rs.500 per bond. This company issued these bonds with a 5% annual coupon rate and a 10-year maturity duration. The corporation decides to repurchase these bonds at their par value after this term.
For this purpose, it creates a sinking fund account where it intends to make deposits twice a year for 10 years. So, the deposit required if the annual coupon rate is 6% will be:
Contribution = 50,00,000 x 0.03/(0.03 + 1) (2×10)- 1 = Rs.1,86,079
Ans: Sinking fund bonds are a kind of bond where the issuer sets aside a pre-determined sum of money so that he or she can repay the bondholders on predefined dates or dates of maturity.
Essentially it is a bond that the issuer issues to serve as collateral if he or she fails to make payments to bondholders on time. For example, a business prepares an initial cash corpus, which it transfers to an independent trustee.
Ans: Bonds are debt instruments that the government issues issued or businesses acquire to raise money from investors for a set period of time. These fixed-income securities enable bondholders to receive periodic interest or coupon payments. As a result, bond issuers are debtors, and bondholders are creditors or investors.
Ans: Sinking funds protect investors when a company issues a corporate bond. These companies set aside money in these accounts to pay any money they owe to these investors. This lowers the default risk because even if the company is going through a loss, it will have money to repay the investors.
Ans: The number of sinking funds you want to keep depends on your needs and the goals you need to meet. Say, for example, you already have set aside money in your savings account for monthly expenses and emergency funds separately for the unpredictable situation. However, now you want to go for a trip next year and buy a car to have two separate sinking funds for such requirements.
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.Disclaimer
