Updated March 4, 2023
Introduction of Capital Reserve
Capital Reserve is termed as reserve build by a company over a period of time by accumulating profits generated through non-operating activities to finance Long Term Projects or to write off its losses or capital expenses in the future. It is a type of account on the company’s balance sheet that is maintained by the company to prepare itself from any unanticipated events that may occur in the future such as Economic Crisis, Inflation, write off capital expenses, Long Term Capital investment projects or expansion of a business.
Example of Capital Reserve
Let’s take an example, Ryan would like to buy land in the future. So, in order to prepare himself, he will start keeping some money aside. Let’s say he created some wealth by selling off his old car and some household stuff along with some money generated from his income. Now he opens up a saving account to save all the money gathered. He can now use this money only to buy the land in the future.
Similarly, if we consider a company XYZ has a plan of business expansion in the near future without taking a huge loan, they can do so by creating a Capital Reserve. If the Company is selling off any property or assets, they can include the amount generated in Capital Reserve. Since the company is not entitled to pay any dividend to shareholders from this capital, they can use the whole amount to invest for expansion.
How Capital Reserve can be Created?
Here are a few examples by which It can be generated:
- Profit earned on the sale of Fixed Assets.
- Profit earned on selling investments.
- Profit received on buying an existing business.
- Profit generated on the revaluation of assets and liabilities.
- Premium received on issuing shares and debentures.
Objectives of Capital Reserve
- Surplus amount in Capital Reserve makes the organization financially strong.
- It helps in writing off financial losses.
- It is used to finance Long Term Projects of the company.
- It helps in issuing bonus shares to shareholders.
- It is maintained in order to protect the company during inflation or Economic Crisis.
- It is used to increase the working capital of an entity.
- It supports future contingencies of a firm.
Capital Reserve vs Revenue Reserve
Revenue Reserve is the reserve created by the net profit that is generated by the company during the financial year. Revenue Reserve is created by regular operations of the business. The reserved amount is not distributed to the share holders but can be distributed if not required.
Difference between Capital Reserve and Revenue Reserve:
- It is created for Long Term Projects while Revenue Reserve is created to handle unexpected events within a business.
- Profit earned through sale of assets or sale of shares goes in capital reserve while profit earned through regular operations goes in Revenue Reserve.
- Capital Reserve mostly used for long term projects while Revenue Reserve is mostly used for short term purposes.
- It is used only for the purpose for which it is created while Revenue Reserve can be used for any purpose.
- It cannot be used as dividends while Revenue reserve can be used to pay dividends.
Goodwill and Capital Reserve
Goodwill represents the extra amount that we pay for purchasing a firm, while capital reserve represents the profit that we earned by acquiring a business or a firm. For example,, Fair value of a Company ABC’s assets and debts is 100,000$. While Company XYZ’s acquired ABC in 120,000$. This extra 20,000$ paid by XYZ will be considered as Goodwill. The account for Goodwill is listed in the assets section of Firm’s Balance Sheet under intangible assets. Although, Goodwill is allocated in assets a financial analyst doesn’t consider Goodwill while analyzing Firm’s asset value. A Capital Reserve is accounted for in the equity section of the Balance sheet, which is the profit that is earned by acquiring another company. Capital Reserve is the actual profit that is then used in future contingencies.
Advantages and Disadvantages
Some of the advantages and disadvantages are given below:
Some of the advantages are given below:
- It supports strengthening the financial stability of a firm.
- It helps to supply the additional requirement of working capital.
- It is a great source of Financing Long Term Investments or business expansion projects.
- It provides a surplus amount that provides additional support during unexpected Economic Crisis, Inflation.
- It helps in issuing fully paid Bonus shares to existing shareholders.
- It helps in writing off economic losses that may occur to the organization in the future.
Some of the disadvantages are given below:
- It can not be distributed as a dividend to shareholders. As a result, Shareholders do not get fair dividend.
- It is quite tough for an organization to determine such reserve fund.
- Since capital reserve only comes from Non–Operating activities and has nothing to do with Trading activities or Business activities of the organization, it does not give any reflection of the operational efficiency of the firm.
- Since capital reserve only comes from Non–Operating activities and has nothing to do with Trading activities or Business activities of the organization, it does not give any indication of real profit earned by the company.
- It is not necessary for a business organization to maintain Capital Reserve.
Capital Reserve is a reserve build by a company over a period of time by accumulating profits generated through non-operating activities to finance Long Term Projects or to write off its losses or capital expenses in the future. This Reserve is maintained by the company to prepare itself from any unanticipated events that may occur in future such as Economic Crisis, Inflation, write off capital expenses, Long Term Capital investment projects or expansion of the business. The capital reserve is a great source for financing Long Term Projects of a firm and company doesn’t need to borrow funds from external sources.
This is a guide to Capital Reserve. Here we also discuss the introduction and how capital reserve can be created along with advantages and disadvantages. You may also have a look at the following articles to learn more –