Revenue Reserve

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is Revenue Reserve?

The revenue reserve is the reserve created out of the company’s profits generated from its operating activities during a period and retained to expand its business or meet contingencies in the future. A Revenue reserve account acts as an internal source of funding or finance and helps grow the company quickly.

Revenue-Reserve

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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 of the company’s operational efficiency.

Key Takeaways

  • Revenue reserves are funds set aside by a company from its profits for future use, such as investments, expansion, or emergencies, showcasing prudent financial planning and foresight.
  • Revenue reserves are crucial in providing financial security and flexibility to the company, enabling it to navigate economic downturns and capitalize on new opportunities, enhancing its resilience and adaptability.
  • Revenue reserves are typically disclosed in a company’s financial statements. 
  • They can be utilized for various purposes, depending on the company’s specific needs, illustrating these reserves’ versatility and strategic utility.

Revenue Reserve Explained

A revenue reserve is created from the net profit generated from the company’s core operations. Companies create revenue reserves to expand the business quickly. 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.read more 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.read more.

Revenue reserve accounting helps a company become stronger from the inside out to serve its shareholders for years to come.

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Video Explanation

Types

These reserves serve as a financial cushion, allowing a business to weather economic downturns or invest in future opportunities. There are two primary types of revenue reserve accounts:

  • General Revenue Reserves: These are also known as retained earnings or undistributed profits. General revenue reserves are accumulated over time from a company’s annual profits. They provide a source of funds for various purposes, such as expanding the business, paying off debts, or distributing dividends to shareholders.
  • Specific Revenue Reserves: Specific reserves are set aside for particular purposes or contingencies. These may include reserves for future capital projects, legal settlements, or taxation liabilities. By earmarking funds for specific needs, a company ensures that it has the necessary resources when these situations arise.

Examples

Now that we understand the basics and types of revenue reserve accounting, let us apply the theoretical knowledge to practical application through the examples below.

Example #1

XYZ Inc. has been consistently profitable over the years. At the end of each fiscal year, the company retains a portion of its profits in the form of general revenue reserves, also known as retained earnings. These retained earnings are not distributed as dividends but are kept within the company for various financial purposes.

For instance, during a particularly challenging year, XYZ Inc. experienced a significant decrease in sales due to an economic downturn. Thanks to their accumulated general revenue reserves, they were able to cover operating expenses, maintain employee salaries, and avoid taking on debt to survive the tough times.

Example #2

After the initial public offering (IPO), Apple Inc. kept all its profits as revenue reserve for a few years. Even though the company was doing considerably well, it could have paid off existing debts or declared dividends. They instead, decided to set aside an amount for the first few years to be reinvested into the business.

The idea was to strengthen the company’s core to serve its 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?

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

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

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

This example shows 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 company’s net profit, which is real money and is available in books and cash.
  • So, we can see that 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 2015 and 2016, respectively.

These amounts will take place on the company’s balance sheet as “retained earnings” in the 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.

Advantages

Let us understand the advantages of revenue reserve account through the points below.

Revenue Reserve Vs Capital Reserve

Both types of reserves are essential components of a company’s financial toolkit, serving different roles in ensuring financial stability and strategic growth. Let us understand the differences through the comparison below.

Revenue Reserves

  • Revenue reserves, also known as earned surplus or retained earnings, are funds accumulated from a company’s annual profits.
  • These reserves represent the portion of profits that a company chooses to retain rather than distribute as dividends.
  • Revenue reserves are a testament to a company’s historical financial performance and are typically used for various purposes, such as reinvesting in the business, covering operational expenses, or servicing debt.
  • They offer financial flexibility and stability.

Capital Reserves

  • Capital reserves, on the other hand, are created from sources other than regular profits.
  • They typically arise from extraordinary events, such as the sale of assets, investments, or revaluation of assets.
  • Capital reserves are earmarked for specific purposes, like acquiring new assets, retiring debt, or handling legal contingencies.
  • Unlike revenue reserves, capital reserves do not originate from operational profits and serve a distinct function in a company’s financial structure.

Frequently Asked Questions (FAQs)

1. What is capital reserve vs. revenue reserve?

Capital reserve refers to a reserve created from capital profits or gains a company earns through non-operating activities, such as selling assets, re-valuating investments, or capital contributions. On the other hand, a revenue reserve is created from the retained earnings or profits earned by a company from its normal operating activities, such as sales of goods or services.

2. What are the types of revenue reserves?

Revenue reserve types include general, specific, and secret reserves. A general reserve is created to meet future contingencies or for general business purposes, and a specific reserve is created for a specific purpose, such as dividends or bonuses. A secret reserve is created by underestimating the value of assets or overestimating liabilities on the company’s financial statements for internal purposes.

3. is revenue reserve a free reserve?

Revenue reserves are considered free reserves, as they are available for distribution among shareholders as dividends or for other corporate purposes, subject to the company’s policies, legal requirements, and financial health. However, it’s important to note that revenue reserves are not distributable as cash or assets until they are properly appropriated or utilized as per applicable laws and regulations.

This has been a guide to what is Revenue Reserve. Here we explain its types, examples, how to create, advantages, and compare it with capital reserve. You may also have a look at the following recommended accounting articles –