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.
- 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 the 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 a cash dividendCash DividendCash dividend is that portion of profit which is declared by the board of directors to be paid as dividends to the shareholders of the company in return to their investments done in the company. Such a dividend payment liability is then discharged by paying cash or through bank transfer. or dividend in kinds. Revenue reserves can be distributed as a dividend in the form of an issue of bonus sharesBonus SharesBonus shares refer to the stocks issued by the companies for free of cost to their existing shareholders in the proportion of their stock holdings. Companies issue such shares to compensate the shareholders with a higher dividend payout in the form of stocks..
- It helps a company become stronger from the inside out so that it can serve its shareholders for years to come.
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.
|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|
|(-) 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 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)|
|(-) Operating Expenses||157,000||133,000|
|– 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.||(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.||(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 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..
- 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..
Here’s a snapshot.
|Stockholders’ Equity||2016 (in US $)||2015(in US $)|
|Total Retained Earnings||23,500 + 24000 = 47,500||24,000|
|Total Stockholders’ Equity||602,500||579,000|
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. 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 –
- Firstly, it can be used as a great source of internal financeSource Of Internal FinanceInternal Sources of Finance are the income sources that a Company generates from within itself to cover its operating expenses or accumulate cash for investment & growth. These include Sales-generated revenue, Retained Profits, & Controlling/Reduction of working capital. to meet the small-term requirements of the business.
- Secondly, it can be distributed if required by shareholders.
- Thirdly, it can be received in real monetary value and also can be existent in the books of accounts.
- Fourthly, it 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 the long term, it always serves the purpose in the short or mid-term contingencies.
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.. 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
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 –