A sinking fund is a fund created specifically to save or set aside money to pay off a debt or a bond. A company may face an immense outlay when the time comes to pay off debts and bonds issued in the past. In this case, a sinking fund helps soften the impact of this large cost. A sinking fund is set up so that a company can contribute and add to the fund over the years leading up to the bond’s maturity.
Sinking fund definition
A sinking fund incorporates funds set aside or borrowed to pay off a loan, debt or any future capital expense at the time of maturity. The purpose of a sinking fund is to reduce the burden and impact of the repayment of the loan or bond upon its maturity.
A Sinking fund allows a particular sense of security and an added layer of protection for an organization and for the investors as well since the use of a sinking fund means that there will be greater availability of money at the time of debt maturity. The risk of default is reduced due to the accumulated amount in the sinking fund by the organization in the years leading up to the maturity of the capital expense. In simpler words, when a sinking fund is set up, the amount to be paid off at the maturity of the debt is lower. This also means that the chances of bankruptcy for the company are reduced greatly by a sinking fund.
A sinking fund is also a good way for a company to improve its creditworthiness. Since a sinking fund is seen as an additional sense of security and allows for lower default risk the interest rates on the bonds are usually lower. This results in the company being viewed as creditworthy and leads to a greater deal of interested investors for the company.
A sinking fund also becomes a tool to increase a company’s cash flow and profitability over time. The sinking fund leads to lower debt-servicing costs due to lower interest rates. This can also increase the likelihood of the company raising additional capital if and when required since the added layers of security increase investor interest in the company.
The benefits of a sinking fund include the availability of a part of, or the entire amount due at the maturity of the bond for the company itself and the benefit of reduced risk of default upon maturity for the investors. However, the drawbacks associated with a sinking fund are unclear. The cost to creditors can increase if the bonds are callable because the organization then has an option on the bond:
- The firm will choose to buy back discount bonds (selling below par) at their market price,
- Exercising its option to buy back premium bonds (selling above par) at par.
Therefore, if interest rates fall and bond prices rise, a firm will benefit from the sinking fund provision that enables it to repurchase its bonds at below-market prices.
In a historical context, sinking funds were initially created in 18th century Great Britain to help settle and reduce the national debt, the primary issue faced at that time was the lack of attention and priority given to the sinking fund. Today, sinking funds are used as a method of bond repayment by setting aside money and contributing to the fund until the point of bond maturity.
A sinking fund also has the alternative use of becoming a fund set up to replace an asset or piece of equipment. For example, a sinking fund is set up in a factory’s accounts to replace a particular machine. As per the machine’s life expectancy and depreciation rate, also taking into account the scrap value of the machinery, the company contributes the right amount into the sinking fund every year to have enough to replace the machine once its life expectancy ends.
Accounting for a sinking fund
A sinking fund is accounted as a non-current asset or long term asset in a company’s balance sheet and is also often included in the list of long-term investments or other investments. Most often seen with capital intensive companies, long term debts and bonds are issued to fund the purchases of new plants and equipment.
Real-world example of a sinking fund
Let’s say that Mehta Oil Ltd, a hypothetical company, issued INR 200 crores in long-term debt in the form of bonds. The bondholders were to be paid their interest amount semi-annually. Mehta Oil Ltd decided to set up a sinking fund whereby they had to contribute INR 40 crores to that fund at the end of each financial year. By the second year in, the company will have saved INR 80 crores and by the third year, INR 120 crores of the total INR 200 crores debt.
What if the company had not opted to set up a sinking fund? Mehta Oil Ltd would have had to pay out the entire INR 200 crores at the end of the 5-year bond maturity period either from their profits, cash, or their retained earnings. That would have been a major debt to pay back all at once especially if you also factor in the cost of interest paid to the bondholders over the entire 5 year period. If the prices of oil collapsed or Mehta Oil Ltd could not arrange for the required sum of money, they wouldn’t have been able to meet their debt payment which could lead to a default in payment.
Setting up the sinking fund allowed the company to pay off less in terms of interest to the bondholders as the years passed by towards maturity of the bond and also allowed less risk to the business of paying off a lump-sum amount that was huge in the long run.
Other types of sinking fund
Sinking funds can also be used to buy back preferred stocks. These are stocks that offer a higher claim to dividend or asset distribution to their stockholders as compared to regular stockholders. The company can set aside a cash deposit through a sinking fund to retire preferred stocks. In some cases, the stock can have a call option attached to it meaning the company has the right to repurchase the stock at a predetermined price.
As mentioned above, sinking funds may also be set up to replace a particular asset with depreciable value over its lifespan, this is especially appropriate for factory machines and vehicles. Sinking funds can also be set up to call for periodic payments to a trustee. The accumulated sum can be used for the retirement of the entire issue at maturity. Instead of the debt amortizing over the life, the debt remains outstanding and a matching asset accrues. In this way, a fund is built up to pay off the debt in full at a specified future date instead of directly paying the debt down over time.
