Sinking Fund

Updated on January 5, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is a Sinking Fund?

Sinking funds are funds that are periodically accumulated by the company as reserve. Later the reserve fund is used for a specific purpose—repayment of debts or repurchase of bonds on maturity. As a result, companies are not burdened with paying a huge sum at once.

The sinking fund also improves a company’s credibility in front of investors. It is a strategic move—companies prepare for future lump sum payments and minimize investors’ risk.

Key Takeaways

  • A sinking fund is a sum accumulated by a company over a period—every month, quarter, or year. These funds serve specific purposes, like debt repayment or bonds redemption.
  • It also provides financial security to the bond investors and thus, increases their trust in the company.
  • Companies use this fund to charge depreciation on an asset over its lifetime. They transfer an equivalent amount to the fund to replace the asset—when the asset’s useful life ends.

Sinking Fund Explained

Sinking Fund

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Sinking Fund (wallstreetmojo.com)

A sinking fund is money kept aside every month, quarter, or year towards a specific purpose. The purpose could be the repayment of a debtDebtDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more, buying back of bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more, etc. It is also called a stockpile, nest egg, or stash. Most corporations use this provision for bonds. It is an added assurance that investors won’t lose money on these bonds.

Bond Sinking Fund

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Sinking Fund (wallstreetmojo.com)

Also, it reduces the company’s burden of disbursing a lumpsum amount at the time of maturity. The company is taking responsibility by creating a fund that reduces bond buyers’ credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more. In such scenarios, companies can negotiate the interest ratesInterest RatesAn interest rate formula is used to calculate loan repayment amounts as well as interest earned on fixed deposits, mutual funds, and other investments. It is also used to calculate credit card interest.read more as well. In addition, companies can add a call feature option to the bonds. As a result, the company can buy the bonds back at the price they want—even if there’s a factorial change in the market.

Also, money can be set apart for future capital purchases—machinery, real estate, or other fixed assetsFixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.read more. Businesses apply the sinking fund method. On the one hand, they depreciate assets—on the other hand, they set aside an equivalent amount as a stockpile. The stockpile is used for replacing depleted assets in the future. Simply put, a stockpile or a stash is a strategy devised to deal with emergencies and huge expensesExpensesAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital.read more in the foreseeable future.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Sinking Fund in Video

 

Types

The four different types of sinking funds are as follows:

  1. Callable Bonds: Such a fund is maintained for calling the bond issued by the company—at a fixed call price.
  2. Specific Purpose Fund: Businesses set funds aside for a specific pre-determined purpose.
  3. Regular Payment Fund: Many organizations separate a certain amount for settling up regular payments—to creditorsCreditorsA creditor refers to a party involving an individual, institution, or the government that extends credit or lends goods, property, services, or money to another party known as a debtor. The credit made through a legal contract guarantees repayment within a specified period as mutually agreed upon by both parties. read more, trusteesTrusteesA trustee is an individual or institution with legal authority to manage the trust property and assets on behalf of the settlor to benefit the beneficiary. They have complete control over the trust assets until they get transferred to the beneficiary. The administration of assets goes as per the directions of the trust. read more, and other parties.
  4. Buying Back Fund: Sinking funds are set aside to buy a bond back upon maturity—from the bondholders—either at the stockpile price or market priceMarket PriceMarket price refers to the current price prevailing in the market at which goods, services, or assets are purchased or sold. The price point at which the supply of a commodity matches its demand in the market becomes its market price.read more.

Formula

The formula for computing the amount of periodic contribution made for the sinking fund is as follows:

computing the amount of periodic contribution

Here,

Example of Sinking Fund

Let us assume that P&R Ltd. issued 100 bonds, each costing $500. The bonds were issued at a 5% coupon rateCoupon RateThe coupon rate is the ROI (rate of interest) paid on the bond's face value by the bond's issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more—payable every year for the next ten years. At the end of this tenure, the company must repurchase the bonds at par valuePar ValuePar value is the minimum value of a security set and stated in the corporate charter or its certificate by the issuer when issued for the first time.read more. Evidently, the company declares it as a sinking fund bond and plans to deposit a sum semi-annually for ten years. Find the stockpile contribution if the annual interest rate is 6% per annum.

Solution:

contribution if the annual interest
  • Money to Accumulate = $500 × 100 = $50000
  • Interest = 6% ÷ 2 = 3% or 0.03
  • Compound Frequency = 2 times (semi-annually)
  • Period = 10 years
semi-annual contributio

Therefore, PQR Ltd.’s semi-annual contribution towards the stockpile is $1860.79. 

Accounting

On a company’s balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more, stockpiles are represented as a long-term investment. This is because such a fund is not utilized within one accounting periodAccounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.read more but is maintained long-term. Till maturity, stockpiles are either invested in secured long-term schemes or deposited to separate bank accounts till maturity. Also, the interest accumulated from the investments is treated as revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more.

Depreciation Method – Journal Entries

DepreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more is one of the main objectives behind creating a sinking fund. Assets are depreciated over their useful lifeUseful LifeUseful life is the estimated time period for which the asset is expected to be functional and can be put to use for the company’s core operations. It serves as an important input for calculating depreciation for assets which affects the profitability and carrying value of the assets.read more, and simultaneously a stockpile is also accumulated. Later, this particular stockpile is used to buy new assets. Henceforth, the following accounting entriesAccounting EntriesAccounting Entry is a summary of all the business transactions in the accounting books, including the debit & credit entry. It has 3 major types, i.e., Transaction Entry, Adjusting Entry, & Closing Entry. read more are formulated:

Depreciation Method - Journal Entries

Frequently Asked Questions (FAQs)

What is the purpose of a sinking fund?

Stockpiles are created to prevent a future shortage of funds—at the time of debt repayment or bond repurchase. Companies possessing a stash do not have to pay large sums from their cash flow. Stashes further propagate the creditworthiness of a business—to the investors.

Is sinking fund a current asset?

No, sinking funds are not current assets. In the balance sheet, they are represented as long-term, noncurrent, or fixed assets. They cannot be converted into cash in a single accounting period.

How does a sinking fund work?

The company keeps a certain sum aside every month, quarter, half-year, or year. This is for repaying a loan or repurchasing bonds (issued earlier). This way, a small amount is saved and invested periodically. By the date of maturity, the company accumulates enough funds for the specified purpose.

This has been a guide to what are Sinking Funds and Meaning. Here we discuss sinking fund definition, formula, calculation, methods, provisions, depreciation, accounting, and examples. You may learn more about fixed income from the following articles –

Reader Interactions

Comments

  1. Dres Wondifraw says

    IT is very interesting knowledge here. I am satisfied while reading the lesson recalling back what I thought in school.

Leave a Reply

Your email address will not be published. Required fields are marked *