What is a Sinking Fund – Meaning, Formula and Example
Financial planning is not just about generating profits or making investments, but also about ensuring that liabilities are repaid on time without placing undue pressure on cash flow. One of the most effective strategies to manage such obligations is the concept of a sinking fund.
Whether in corporate finance, government debt, or even personal money management, a sinking fund plays a crucial role in creating financial discipline and stability.
In this article, we will explore what a sinking fund is, its purpose in India, whether it is considered an asset or a liability, why it is called a sinking fund, and how to calculate it using a formula and examples.
What does sinking fund mean?
A sinking fund is essentially a reserve or pool of money set aside over time to repay a long-term debt, replace an asset, or meet a future obligation. The key idea is gradual accumulation. Instead of waiting until the maturity date to arrange a large lump-sum payment, small amounts are systematically set aside in the fund.
This concept is particularly popular in bond and debenture repayment. Companies that issue bonds often create sinking funds to assure investors that repayment is secured. Similarly, governments may use sinking funds to ensure the timely repayment of loans taken for infrastructure or development projects.
For individuals, a sinking fund can mean setting aside money every month for a major purchase or expense, such as buying a car, renovating a house, or planning a wedding.
Purpose of a Sinking Fund
- Debt repayment – Reduces the risk of default for companies or governments.
- Asset replacement – Ensures funds are available when an expensive asset, such as machinery, equipment, or property, needs to be replaced.
- Investor confidence – Helps bondholders and investors trust the issuer’s financial discipline.
- Financial discipline – Encourages regular savings rather than scrambling for funds at the last minute.
Sinking Fund Formula
The sinking fund calculation involves determining how much needs to be set aside periodically to reach a desired future sum. The formula is:
A = (S × r) / ((1 + r)n – 1)
Where:
- A = Periodic sinking fund payment
- S = Future sum to be accumulated
- r = Interest rate per period
- n = Number of periods
This formula is derived from the future value of an ordinary annuity and is widely used in both corporate finance and personal financial planning.
Example of Sinking Fund Calculation
Suppose a company issues bonds worth ₹50 lakh that will mature in 5 years. To ensure repayment, the company decides to create a sinking fund. They want to accumulate the entire amount by earning 6% annual interest.
This means the company must deposit around ₹8.88 lakh every year into the sinking fund. At the end of 5 years, the fund will accumulate to ₹50 lakh (plus interest earned), which can be used to repay bondholders.
This example highlights the benefit of spreading out payments over multiple years rather than arranging a large sum at maturity.
What is the sinking fund in India?
In India, the concept of a sinking fund is not limited to private corporations but extends to governments and municipalities as well.
Corporate Sector in India
Many Indian companies issue debentures or bonds to raise capital. Under the Companies Act, in certain cases, it is mandatory for companies to create a Debenture Redemption Reserve (DRR) or sinking fund. This ensures that they do not default on repayment at maturity. By law, a part of profits may need to be transferred to this reserve annually until the bonds are redeemed.
For example, if a company issues debentures worth ₹100 crore, it may transfer a percentage of profits into a sinking fund each year. This instills confidence in investors and helps companies raise funds more easily in the future.
Government Sector in India
State governments, the central government, and municipal corporations in India often set up sinking funds for repayment of public loans. For instance:
- Municipal bonds used to fund urban development projects often come with sinking fund provisions.
- State governments may maintain sinking funds to repay market borrowings.
The Reserve Bank of India (RBI) also monitors and manages some of these funds to ensure fiscal stability.
Personal Finance in India
For individuals, sinking funds are becoming increasingly popular. Instead of relying on credit cards or personal loans for big expenses, many households in India create their own sinking funds. Examples include:
- Saving monthly for a child’s education.
- Setting aside money for a down payment on a house.
- Planning for yearly travel expenses.
This practice prevents debt accumulation and ensures financial discipline.
Is a sinking fund an asset or a liability?
One common question is whether a sinking fund should be treated as an asset or a liability.
The answer is:
- A sinking fund is an asset because it represents money set aside and invested for future use. On the balance sheet, it appears on the asset side, often under the category “Investments” or “Cash and Bank Balances.”
- However, the obligation for which the sinking fund is created — such as bond repayment — is a liability.
For example, if a company has issued bonds worth ₹10 crore, that amount is shown as a liability. Meanwhile, the money deposited each year into the sinking fund (say ₹2 crore annually) is shown as an asset. When the bonds mature, the asset (sinking fund) is used to settle the liability (bonds payable).
So, while the sinking fund itself is an asset, its purpose is directly linked to repaying liabilities.
Why are they called sinking funds?
The term “sinking” in sinking fund signifies the gradual reduction, or “sinking,” of debt over time. Rather than making one massive payment at the end, the borrower systematically reduces the outstanding obligation by setting aside funds regularly.
For instance, if a company owes ₹50 crore in 10 years, it doesn’t need to scramble for the full amount when the bonds mature. By creating a sinking fund, it deposits smaller sums annually, and the debt burden gradually “sinks” until it disappears.
This mechanism not only provides peace of mind to borrowers but also enhances investor trust, since they know that repayment is planned and secure.
Advantages of Sinking Funds
- Reduced risk of default – Investors are assured that the issuer has funds to repay.
- Financial discipline – Encourages regular savings instead of last-minute borrowing.
- Lower interest costs – Companies with sinking funds are seen as less risky and may get better interest rates when issuing bonds.
- Flexibility in asset replacement – Businesses can replace machinery or infrastructure without straining cash flow.
- Improved credit rating – Maintaining a sinking fund strengthens the issuer’s creditworthiness.
Disadvantages of Sinking Funds
While sinking funds are beneficial, they also have some drawbacks:
- Reduced liquidity – Money tied up in a sinking fund cannot be used for other business opportunities.
- Lower profits – Companies must divert a portion of their earnings, which could otherwise be reinvested.
- Administrative burden – Managing and investing sinking funds requires additional effort.
Despite these drawbacks, most financial experts agree that the advantages outweigh the disadvantages, especially in long-term debt management.
Conclusion
A sinking fund is a powerful financial tool that ensures debt repayment and asset replacement without last-minute stress. By setting aside money regularly, companies, governments, and even individuals can meet large obligations in a structured way.
In India, sinking funds play a vital role in corporate finance and government borrowings, while individuals also use them for personal financial planning. Although the fund itself is an asset, it exists to cover future liabilities, particularly long-term debts.
The name “sinking fund” comes from the gradual “sinking” of debt until it is fully repaid. Whether for corporations managing bond repayments, governments financing infrastructure, or households planning major expenses, sinking funds remain an essential part of sound financial management.