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Revenue Reserve vs Capital Reserve | Top 7 Differences

Revenue Reserve vs Capital Reserve – Reserves are one of the most notable appropriations of profits. Companies create reserves so they can be ready to face any contingencies in near future.

Reserves in a company can be divided into two broad categories – one is Capital Reserve and another is revenue reserve.

Revenue reserve is created from the net profit companies make out of their own operations. Companies create revenue reserve to quickly expand the business. And revenue reserve also helps the companies to source their capital from their own internal profits. As an example, we can talk about retained earnings.

A capital reserve, on the other hand, is created out of capital profits. The purpose of capital reserve is to prepare the company for any unforeseen events like inflation, instability, need to expand the business, or to get into a new and urgent project. As an example, we can talk about profit on the sale of fixed assets, profit on sale of shares etc.

In this article, we will do a comparative analysis between these two reserves.

Let’s get started.

  • Revenue Reserve vs Capital Reserve Infographics
  • What is Revenue Reserve?
    • Revenue Reserves Example
  • What is Capital Reserve?
    • Capital Reserve Examples
  • Revenue Reserve vs Capital Reserve – Key differences
  • Revenue Reserve vs Capital Reserve (Comparison Table)
  • Conclusion

Revenue Reserve vs Capital Reserve Infographics

There are multiple differences between revenue reserve vs capital reserve. Let’s have a look at them one by one.

Now that we understand the broad differences between Revenue Reserves vs Capital Reserves, let us look at these individual terms in detail.

What is Revenue Reserve?

Revenue reserve is one of the best resources for internal finance.

When a company earns a lot in a year and makes huge profits, a portion of the profits is set aside and reinvested in the business. This portion is called revenue reserve or in common term “retained earnings”.

The rest of the profit is distributed to the shareholders as dividends. Sometimes, the whole profits are distributed as a dividend to the shareholders.

A company can distribute cash dividend or dividend in kinds. Revenue reserves can be distributed as a dividend in the form of an issue of bonus shares.

Revenue reserve helps a company become stronger from inside out so that it can serve its shareholders for years to come.

As an example, we can talk about Apple. After the initial public offering (IPO), Apple kept all its profits as revenue reserve for few years. The idea is to strengthen the core of the company so that they can serve their customers and shareholders better. Look at Apple now. It is a thriving business and one of the most valuable brands in the world.

Revenue Reserves Example

In this section, we will take a fictitious example and will see how we can create revenue reserve from the profits of the business.

One thing we need to understand here is that revenue reserve of a company isn’t just on the books of the company. It’s the real money and is made out of real profits.

So, let’s get started.

Particulars 2016 (in $) 2015 (in $)
Gross Sales & Revenue
–       New Line of Bag Sales                          198,000 Nil
–       Other Bag Sales                        450,000 360,000
–       Sales of Accessories                 142,000   120,000
    790,000 480,000
(-) Total Sales Returns   (30,000) (15,000)
Net Sales Revenue   760,000 465,000
(-) Total Cost of Sales (518,000) (249,000)
–       Cost of sales for new line of bags (254,000) Nil
–       Cost of sales for other bags (190,000) (182,000)
–       Cost of sales for accessories (74,000) (67,000)
Gross Profit   242,000 216,000
(-) Operating Expenses   157,000 133,000
–       Selling, general & administrative expenses (123,000) (93,000)
–       Insurance expenses (12,000) (11,000)
–       Other expenses (22,000) (29,000)
Operating Profit (EBIT) 85,000 83,000
(-) Interest & Expense (23,000) (18,000)
Profit from operations before income taxes (PBT) 62,000 65,000
(-) Income tax (15,000) (17,000)
Net Profit (PAT) 47,000   48,000

In this example, you can see how the “net profit” is computed in the income statement.

Revenue reserve is created by using the net profit of the company which is real money and it is available in books as well as in cash.

So, we can see that for the net profits for two consecutive years 2015 and 2016 are $48,000 and $47,000 respectively.

If we assume that 50% of the net profits will be transferred to revenue reserve or retained earnings, the amount would be $24,000 and $23,500 for the year 2015 and 2016 respectively.

These amounts will take place in the balance sheet of the company as “retained earnings” in shareholders’ equity statement.

Here’s a snapshot.

Stockholders’ Equity 2016 (in US $) 2015(in US $)
Preferred Stock 55,000 55,000
Common Stock 500,000 500,000
Retained Earnings 23,500 24,000
Total Stockholders’ Equity 578,500 579,000

These retained earnings can be used as “undistributed profits” to reinvest in the business. Or these can be distributed as dividends to shareholders or can be issued as bonus shares.

Creating revenue reserve for a company can be useful because –

  • Firstly, it can be used as a great source of internal finance to meet the small term requirements of business.
  • Secondly, it can be distributed if required among shareholders.
  • Thirdly, it can be received in real monetary value and also can be existent in the books of accounts.
  • Fourthly, revenue reserve can also be used to replace old assets (which are the immediate needs of the business) or to pay off an urgent liability. Since revenue reserve is not kept for long term, it always serves the purpose in the short or mid-term contingencies.

Is there any relationship between operating efficiency and the amount of retention?

On the surface, it would seem that there’s no relationship between operating efficiency of a business and the retention ratio.

But in actuality, a company would be able to retain more when the “net profits” are noteworthy. And if we look at the ratio between “net profit” and “total capital employed”, we will get a clear idea about operational efficiency of the company.

If a company retains $100,000 as revenue reserve (which is 25% of the “net profit”); the net profit must be $400,000. That means revenue reserve is an indirect indicator of how operationally efficient a company is.

What is Capital Reserve?

Capital reserve works in quite a different way. When a company sells off its assets and makes a profit, a company can transfer the amount to capital reserve.

Since a company sells many assets and shares and can’t always make profits, the capital reserve is used to mitigate any capital losses or any other long term contingencies.

The capital reserve has nothing to do with trading or operational activities of business. It is created out of non-trading activities and thus capital reserve can never be an indicator of the operational efficiency of the business.

Another thing that is important about capital reserve is the nature of it. It is not always received in the monetary value but it is always existent in the book of accounts of the business.

Let’s take an example to illustrate this.

Capital Reserve Examples

Instead of taking a business perspective, let’s first consider an individual perspective.

Let’s say that you would like to buy a land in future.

So, you begin to set aside some money, sell off old stuffs at your home, sell off the old car you have, and set aside some money from your income.

And you create one savings account to save all of the money you gathered for the new land.

You’re not entitled to do anything with that money other than buying the land for yourself in future.

Now, let’s extend the similar example to businesses.

If a company decides to build a new office building, they need capital.

And they don’t want to loan a huge amount from outside as the cost of capital in that case would be huge.

So, they plan to build the new building by creating a capital reserve.

They decide to sell off the lands and old assets of the company. And then the money received from these transactions is transferred to the capital reserve.

Since the company is not entitled to pay any dividend to the shareholders out of their capital reserve, they can use the entire amount for building a new office building for the company.

This is how capital reserve is used.

However, there are exceptions.

Sometimes, the capital reserve is not created for any particular long term project. Rather when a company feels that they need to be prepared for any economic instability, inflation, recession, or cut-throat competition, they can set aside money from the profits they make on selling off assets or from purchasing a small company and can create a capital reserve.

Capital reserve can also be used for mitigating any capital losses. Since the profits on the sale of assets are not always received in the monetary value, they are caught in the books of the accounts. It is similar with the losses on sale of assets. So, using the capital reserve, the company can set off the capital losses.

For example, let’s say that MNC Company has made a profit of $20,000 on the sale of an old fixed asset. But, it also has expected that they would incur a loss of $18,000 for the sale of old machinery because it has almost become obsolete.

So, MNC Company quickly decides to create a capital reserve of $18,000 out of the profit of $20,000 they have made from the selling of an old fixed asset and can be prepared to write off the loss of $18,000.

Since, capital reserve is under the complete control of a business, it can be used to write off capital losses.

Capital reserve is also created sometimes for legal purposes and to maintain a sound accounting practice within the company.

So, it’s clear that capital reserve is a great source for financing any long term project of the company. A company which isn’t very keen to do the funding from external sources (like debt, term loan etc.) can use capital reserve to fully finance their new project.

Revenue Reserve vs Capital Reserve – Key differences

There are many differences between revenue reserve vs capital reserve. But here are the most important ones –

  • Revenue reserve is created from the trading or operating activities of business. But capital reserve is created from the capital profits of the business which are always non-operational in nature.
  • Revenue reserve can be distributed as dividends to shareholders. Capital reserve, on the other hand, is used for funding a company’s own project/s or to prepare for any future contingency.
  • Revenue reserve is useful for short and mid-term urgency/requirement. The capital reserve is useful for long term purposes.
  • Revenue reserve is always received in monetary terms. The capital reserve is not always received in monetary value.
  • The popular example of revenue reserve is retained earnings. The popular example of capital reserve is reserve created out of profits made for selling off assets of the company.

Revenue Reserve vs Capital Reserve (Comparison Table)

Basis for Comparison – Revenue Reserve vs Capital Reserve Revenue Reserve Capital Reserve
1.    Inherent meaning Is created from trading activities of business. Is created from non-trading activities of business.
2.    Application Acts as a reinvesting source for the business. Acts as a provision for future contingencies like inflation, instability etc.
3.    Distribution Can be distributed as dividend to shareholders depending on the discretion of the company. Is never distributed.
4.    Term Is useful for short and mid-term purposes. Is useful for long term purposes.
5.    Monetary value Can always be received in monetary value. Can’t always be received in monetary value.
6.    Other purpose – Revenue Reserve vs Capital Reserve A portion is always reinvested to the company or distributed as a dividend. Can also be used for legal purposes.
7.    Examples Retained earnings. Reserve created out of profit on sales of fixed assets.

Conclusion – Revenue Reserve vs Capital Reserve

Revenue reserve and capital reserve both serve specific purposes.

Revenue reserve, on one hand, gets created so that the core of the business can get strengthened. Capital reserve, on the other hand, serves many purposes – from writing off a capital loss to finance a new project to prepare provisions for future contingencies.

Revenue reserve is a reserve that shareholders can claim a share of. The shareholders can ask for a dividend if the entire amount of the “net profit” is plowed back to the business. If the company can convince the shareholders that reinvesting the entire amount into the business will only generate better profits, then the issue would be solved.

Capital reserve can’t be shared as dividends to shareholders. And shareholders can’t claim their share as well. It is prepared just for the business to achieve urgent, long-term goals.

Suggested Readings

Hope you enjoyed the article on differences between revenue reserve and capital reserve. Here are the other set of articles that you may like –

  • Negative Shareholders Equity
  • Dividend Yield Ratio Formula 
  • Capital Receipts vs Revenue Receipts
  • Assets vs Liabilities

The post Revenue Reserve vs Capital Reserve | Top 7 Differences appeared first on Learn Investment Banking: Financial Modeling Training Online.

This post first appeared on Free Investment Banking Tutorials |WallStreetMojo, please read the originial post: here

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Revenue Reserve vs Capital Reserve | Top 7 Differences


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