Sinking Fund - Meaning, Formula, Examples and How to Calculate

Difference between sinking fund and savings / current accounts

The main difference between sinking fund and savings / current accounts is that, sinking funds are setup for a specific purpose, while most of the time savings / current accounts serve general purpose liquidity needs. You can draw from savings / current accounts to meet your current expenses, while sinking fund is for future obligations or expenses.

Formula for sinking fund

When you are setting up a sinking fund, you need to know, how much you have save on a regular basis to meet your future obligation. The formula for how much you need to save is as follows:-

S = (P * i)/ {1 – (1+i) ^ (-n)}

Where,

• S = Amount you need to save every year
• P = Future requirement or loan outstanding
• i = Interest rate
• n = Number of years

Uses of sinking fund

Here are some examples, where sinking funds can be used to serve different needs:-

• Bond maturity payment: A company which has issued a bond, will setup a sinking fund to pay the maturity amount to the investor when the bond matures. According to Company’s Act 2013, “the company shall create a debenture redemption reserve account out of the profits of the company available for payment of dividend and the amount credited to such account shall not be utilized by the company except for the redemption of debentures” (source: Company’s Act 2013, Section 71, Point 4). The debenture redemption reserve is essentially a sinking fund.
• Replacement of machinery: Companies set up sinking funds for the purpose of replacing machinery and equipment, when they come to end of their useful life. With a sinking fund, the company can invest in capex from their own reserves instead of taking a loan and incurring interest expenses.
• Housing societies repairs and maintenance: Housing societies from time to time, have to incur large expenses for repairs and maintenance e.g. painting, water proofing, replacing equipments like pumps, electrical panels etc. For this purpose they setup a sinking fund, in which members regularly contribute.
• Housing societies repairs and maintenance: Housing societies from time to time, have to incur large expenses for repairs and maintenance e.g. painting, water proofing, replacing equipments like pumps, electrical panels etc. For this purpose they setup a sinking fund, in which members regularly contribute.

Individual investors or families can also setup sinking funds for different purposes:-

S = (20*5%) / {1-(1+5%)^(-10)} = Rs 2.72 lakhs

Conclusion

There are several benefits of having a sinking fund to meet your future obligations. You can plan well in advance, be better prepared, avoid taking a loan and be free from mental stress to arrange for a large payout. Consult with your financial planner or advisor if you want to know more about sinking funds.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.