Sinking Fund

Mishaps do not come knocking on the door. Disasters can make a state run dry in its funds while handling the devastating outcomes and taking care of the natives. This is why a fund is created in every state which is similar to that of an emergency financial reserve. This fund is called a sinking fund or debt remittance fund. This fund can be used in any case when a state is in dire need of money or has to cover the debt it has taken to tackle a particular situation. As per the information from the Indian Government, there are only 23 states that have developed sinking funds. Let us learn more about this fund and its objectives.

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Financial Steps to Tackle Future Issues

Every company or statehood needs money to run the operations. At times, the company might have to incur losses or borrow money from the banks or government institutions to strengthen its financial foundation. Similarly, a state can also seek financial aid from the central government during the time of need. It can be a natural calamity or anything devastating that has crashed its economy to a considerable extent.

This is where a state or a company maintains a fund where it keeps money aside to create a lump sum amount and to use it during any crisis. This money can also be used for returning the debt or the money it has taken during critical times. This is a common concept you will witness practiced by the private or public companies, states, or even a central government of a country.  The state and central government create a sinking fund to help its people and to provide financial aid to survive any upstream situation. This is a debt that a state or central government incurs and will have to pay back with proper interest to the sinking funds. Let us learn the technical meaning of this fund first to understand its importance.

What is a Sinking Fund?

As mentioned earlier, a sinking fund is formed by a company, state government, or the central government where money is deposited every month or on a regular interval based on the income of the state or the central government. An amount is fixated that the account holder will have to deposit every month or on the interval as directed in that account and the money can only be withdrawn in case of an emergency. According to the definition, we can easily understand that this account is kind of a recurring deposit account where a fixed amount of money is deposited and it increases following a compound interest rate. This fund eventually becomes a huge amount due to regular deposition and the addition of the interest on the principal amount.

This amount is then used by the account holder to repay debt or to meet with critical circumstances and help the linked entities to overcome hardships. The fundamental objective of this fund is to maintain a reserve fund that can be used later to seek financial strength during crises from its own money.

As per its definition, it can also be termed as the debt remittance fund as the amount deposited at regular intervals is used to remit any outstanding debt of the account holder. The account holder can be a state government, the central government, or even a small company. The prime benefit of this fund is that the account holder will not have to face a financial burden when a loan matures and the entire sum will have to be paid to the lender.

The definition of the sinking funds has been depicted by the 12th Finance Commission (2005-10) that every state should create a sinking fund for such purposes. In fact, the commission has also directed that the fund will only be used to repay the loans a state government has taken from the central government during any crisis or for infrastructure development. As per its definition, it is different from that of the public accounts and consolidated sinking fund.

Objectives of Sinking Fund

The name of this fund is somewhat misleading as the readers will think that it is used for remitting the consequences of circumstances that an account holder is facing. If you consider the actual meaning of this fund then you can understand its direct objectives.

This fund is created to meet the liabilities of a company, state, or central government. As per its definition from the commerce platform, this fund is used for the repayment of debts and redemption of debentures. This is why the account holder will continue to input money in that account at regular intervals considering the profit/loss he is making in that year. This type of fund is created to add a buffer between the amount spend and the amount to recur from the market.

The objectives of sinking fund also suggest that the account holder will also be able to redeem old assets and can look out for new assets. This amount can also be used for investment in resources, strengthening infrastructure, and diversification of business.

Example of Sinking Fund

To understand this concept, let us take a sinking fund example. Every state faces a change of government after a span of 5 years. If the preexisting government is not in the ruling position in the next phase, it will pass on the debts it has taken to manage operations to the next government. It will become a huge burden for the upcoming government to handle such situations where it has to govern the state, replenish resources, make contingency plans, and pay off the debts the previous government has made. This is where the concept of sinking funds can be remarkably used to pay off the debts of the previous government of a state.

For instance, if the West Bengal government has issued a bond of INR 100 Crore bond for a tenure of 10 years, it will have to deposit INR 10 Crore every year to fulfill it. For the sake of example, the interest rate has not been considered.

What is the Sinking Fun Factor?

As per the 12^th Financial Commission, the sinking fund factor is considered to be the amount that equals 1% to 3% of the entire debt a state government has to repay. This percentage is calculated based on the total debt present in a consolidated sinking fund. The sinking fund formula is calculated considering this percentage and the amount present in this fund.

What is a Consolidated Sinking Fund?

As per the direction of the Reserve Bank of India, a consolidated sinking fund was established that states can participate and deposit their funds as directed at regular intervals. The amount is calculated following the sinking fund factor in the formula. It was formed in the year 1999-2000 and 23 states are a part of this plan. The fund is obviously managed by the Reserve Bank of India.

From the definition and description of the sinking fund, we can easily understand that the financial benefit of creating such funds is immense. A state or a country will be able to make exceptional decisions based on the financial strength it has prepared for a fixed tenure. In fact, this concept is also used by companies to avoid getting on the defaulter list for loans.

The account holders of sinking funds can use this money to grow or to repay loans. They can also diversify their businesses or invest in new assets. The financial impact of this fund is quite remarkable for the governments if you consider the dwindling economic conditions and other hurdles in India. Understand the concepts of sinking funds and their impact on the Indian economy. Its importance is quite crucial for the state governments or the account holders of the consolidated sinking fund in terms of seeking loans and repayment of debts.