What is a Sinking Fund?

Last Updated: 13 Jan 2025

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 & Meaning

A sinking fund is a strategic financial tool that is used to set aside money over time for a specific purpose or future obligation. It provides a structured approach to managing anticipated expenses or debt repayments. Here are some key aspects of its definition and meaning:

• Purpose-Oriented Savings: A sinking fund is earmarked for a particular goal, such as buying a car, funding a vacation, or paying off a loan.
• Gradual Accumulation: Sinking funds prevents a huge one-time payment but rather saves a small amount over time, thereby easing the burden of finance.
• Debt Management Tool: Businesses use sinking funds to repay bonds or loans. This way, when the bond or loan is due, the company has enough money.
• Financial Stability: The sinking funds ensure that unexpected financial strain is avoided and, in turn, no borrowing takes place.
• Budget-Friendly: Sinking funds ensure disciplined savings for specific needs without disturbing everyday finances.
• Personal Uses: People use sinking funds to achieve personal goals, and business enterprises use them to manage liabilities or capital expenditures.

Sinking funds encourage financial organisation by breaking large expenses into manageable savings over time and reducing reliance on credit or emergency savings.

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.

Types of Sinking Funds

Sinking funds are versatile financial tools tailored for specific purposes. Here are common types:

• Debt Repayment Sinking Fund: Used by businesses or individuals to save for repaying loans or bonds, ensuring timely and stress-free repayments.
• Asset Replacement Sinking Fund: Allocated to replace or upgrade costly assets, like machinery or vehicles, without financial strain.
• Emergency Fund: This fund is reserved for unexpected expenses, such as medical emergencies or urgent home repairs, and offers a financial safety net.
• Education Fund: Set aside for future educational expenses, like tuition fees or professional certifications, ensuring uninterrupted learning.
• Retirement Fund: Dedicated to building a secure financial future post-retirement, providing stability and peace of mind.

Formula of Sinking Funds

The formula to calculate the sinking fund amount is based on compound interest principles:
S= FV/(1+r)n−1×r
Where:

• S = Periodic payment
• FV = Future value or target amount
• r = Interest rate per period
• n = Total number of periods

This formula helps calculate the regular contributions required to reach a specific financial goal, considering the interest earned on savings. It’s useful for individuals or businesses planning future expenses or debt repayment.

Method to Calculate Sinking Fund

To calculate a sinking fund:

1. Calculate the target amount needed (future value).
2. Decide on the time period (number of periods) to save.
3. Identify the interest rate if the fund earns returns.
4. Use the sinking fund formula for periodic contributions.

Alternatively, you can do it manually by dividing the total amount by the saving periods if there is no interest. This way, you will have consistent and systematic savings for your financial goal.

How to Start a Sinking Fund?

Setting up a sinking fund is straightforward, but it fosters discipline and savings toward certain goals.

• Define a goal, such as going on vacation or paying off a loan.
• Determine the amount needed and timeframe.
• Divide the amount into regular periodic contributions.
• Maintain the sinking fund separate from general savings through an isolated account.
• Use automated transfers for routine and systematic management.
• Keep monitoring how you are progressing toward the target.

Benefits of a Sinking Fund

• Financial Preparedness: Helps save for planned expenses, avoiding last-minute financial stress.
• Reduced Debt: Limits reliance on loans or credit cards by providing funds for large purchases.
• Improved Budgeting: Encourages disciplined and structured saving habits.
• Goal Achievement: Makes reaching financial goals more manageable through incremental savings.
• Emergency Fund Protection: Prevents dipping into emergency savings for planned expenses.
  Sinking funds provide financial security and ensure that specific goals are met efficiently.

Conclusion

A sinking fund is a powerful financial tool for individuals and businesses alike. Breaking down large financial goals into smaller, periodic savings fosters discipline and reduces stress. Whether saving for personal milestones or repaying debts, sinking funds enhance financial planning and promote long-term stability.

Frequently Asked Questions

What is a sinking fund in property?

A sinking fund in property is a reserve held by homeowners or residents. The purpose of the fund is to meet larger and possibly unexpected needs such as fixing damaged floors or fixing pipeline leaks in the house walls.

Are sinking funds mandatory?

In most cases, sinking funds are not mandatory but they are a method of avoiding future financial hurdles, default or bankruptcy for any business, hence although not always mandatory, a sinking fund is highly recommended.

What is the difference between savings and sinking funds?

Savings are general-purpose funds set aside for future needs while sinking funds are specifically allocated for planned expenses, like a vacation or car repair. Sinking funds provide a structured approach to saving for targeted goals, preventing the need to dip into emergency or general savings.

Is a sinking fund risky?

No, a sinking fund is not inherently risky. It involves saving money incrementally for a specific purpose and reducing financial strain when expenses arise. The risk level depends on where the funds are held—keeping them in a low-risk account ensures safety.

Is a sinking fund refundable?

A sinking fund itself is not refundable, as it represents money you set aside for a future expense. However, if the planned expense no longer applies, you can redirect the funds toward another goal or return them to your general savings.