Revenue Reserve

What is Revenue Reserve?

The revenue reserve is the reserve that is created out of the profits of the company generated from its operating activities during a period of time and retained for the purpose of expanding its business or to meet out contingencies in the future.

Revenue reserve is created from the net profit generated from the company’s core operations. Companies create revenue reserves to quickly expand the business. It is one of the best resources for internal finance.

Revenue-Reserve

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For eg:
Source: Revenue Reserve (wallstreetmojo.com)

Revenue Reserves Example

As an example, we can talk about Apple. After the initial public offering (IPO), Apple kept all its profits as revenue reserve for a 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.

How to create Revenue reserve from Profit?

In this section, we will take an example to see how we can create revenue reserves from the profits of the business.

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

So, let’s get started.

Particulars2016 (in $)2015 (in $)
Gross Sales & Revenue
–       New Line of Bag Sales                         198,000Nil
–       Other Bag Sales                       450,000360,000
–       Sales of Accessories                 142,000120,000
 790,000480,000
(-) Total Sales Returns(30,000)(15,000)
Net Sales Revenue760,000465,000
(-) Total Cost of Sales(518,000)(249,000)
–       Cost of sales for a 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 Profit242,000216,000
(-) Operating Expenses157,000133,000
–       Selling, general & administrative expensesAdministrative ExpensesSelling, general and administrative (SG&A) expense includes all the expenses incurred in the selling of the products of the company whether direct or indirect along with the entire general and the administrative expenses during an accounting period under consideration such as advertisement expenses, sales promotion expenses, marketing salaries, etc.read more(123,000)(93,000)
–       Insurance expensesInsurance ExpensesInsurance Expense, also called Insurance Premium, is the amount a Company pays to obtain an insurance contract for covering their risk from any unexpected catastrophe. You can calculate it as a fixed percentage of the sum insured & it is paid at a daily pre-specified period. read more(12,000)(11,000)
–       Other expenses(22,000)(29,000)
Operating Profit (EBIT)85,00083,000
(-) Interest & Expense(23,000)(18,000)
Profit from operations before income taxes (PBT)62,00065,000
(-) Income tax(15,000)(17,000)
Net Profit (PAT)47,00048,000

In this example, you can see how the “net profit” is calculated in the income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more.

  • It 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 + 24,000 = 47,500 for the year 2015 and 2016, respectively.

These amounts will take place on the balance sheet of the company as “retained earnings” in shareholders’ equity statement Equity StatementShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders' Equity Statement on the balance sheet details the change in the value of shareholder's equity from the beginning to the end of an accounting period.read more.

Here’s a snapshot.

Stockholders’ Equity2016 (in US $)2015(in US $)
Preferred Stock55,00055,000
Common Stock500,000500,000
Total Retained Earnings23,500 + 24000 = 47,50024,000
Total Stockholders’ Equity602,500579,000

These retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more 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.

Revenue Reserve Advantages

Following are the advantages of creating revenue reserve –

Is there any relationship between operating efficiency and revenue reserve?

On the surface, it would seem that there’s no relationship between the operating efficiency of a business and the retention ratioRetention RatioRetention ratio indicates the percentage of a company’s earnings which is not paid out as dividends but credited back as retained earnings. This ratio highlights how much of the profit is being retained as profits towards the development of the firm.read more. 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 the operational efficiency of the company.

If a company retains $100,000 as a 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.

Revenue Reserve Video

Recommended Articles

This has been a guide to what is Revenue Reserve. Here we discuss revenue reserve examples, how to create revenue reserve from profit, advantages, and its relationship with operating efficiency. You may also have a look at following recommended accounting articles –