Revenue Reserve

What is Revenue Reserve?

Revenue reserve is created from the net profit generated from the company’s core operations. Companies create revenue reserve 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 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.
• 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 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.

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How to create Revenue reserve from Profit?

In this section, we will take an example to 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.

• 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.

Here’s a snapshot.

Stockholders’ Equity	2016 (in US $)	2015(in US $)
Preferred Stock	55,000	55,000
Common Stock	500,000	500,000
Total Retained Earnings	23,500 + 24000 = 47,500	24,000
Total Stockholders’ Equity	602,500	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.

Revenue Reserve Advantages

Following are the advantages of creating revenue reserve –

• Firstly, it can be used as a great source of internal finance 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 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.

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 –

• How Initial Public Offering Works?
• How to Calculate Retained Earnings?
• Dividend Payout Ratio Formula
• Income Statement Examples
• Explanation of Dividend Yield Formula
• Shareholders Equity Statement