Capital reserves

3 Key Takeaways

• Capital reserves are accumulated funds from profits, not used for regular business operations.
• They serve as a buffer against future expenses, investments, or unforeseen losses.
• Examples include share premium accounts and revaluation reserves.

What are Capital Reserves?

Capital reserves are part of a company’s shareholders’ equity, distinct from share capital and retained earnings. They are derived from various sources, primarily from:

• Share Premium: The amount received by a company in excess of the nominal value of its shares when issuing new equity.
• Asset Revaluation: Upward adjustments in the value of a company’s fixed assets, such as property or equipment.
• Capital Redemption Reserve: Created when a company redeems its own shares.

Importance of Capital Reserves

• Financial Buffer: Capital reserves provide a cushion to absorb losses or cover unexpected expenses, enhancing the company’s resilience in facing financial challenges.
• Investment Capacity: They can be used to fund future investments or acquisitions, supporting the company’s growth and expansion plans.
• Dividend Stability: In times of lower profits, capital reserves can be used to maintain dividend payments to shareholders, signaling stability and confidence.
• Financial Strength: Healthy capital reserves are often seen as a sign of financial strength and prudence, attracting investors and lenders.

How Capital Reserves Work

Capital reserves are typically created by transferring funds from the company’s profit and loss account into the reserve account. These funds are not available for distribution as dividends but can be utilized for specific purposes allowed by the company’s articles of association or applicable laws.

Examples of Capital Reserves

• Share Premium Account: This reserve is created when shares are issued at a premium above their nominal value. It can be used for various purposes, such as writing off preliminary expenses or issuing bonus shares.
• Revaluation Reserve: This reserve arises when the value of a company’s fixed assets is revalued upwards. It cannot be distributed as dividends but can be used to offset any subsequent downward revaluation of the same assets.
• Capital Redemption Reserve: This reserve is created when a company redeems its shares, ensuring that the capital base is not diminished and the interests of creditors are protected.

Real-World Application

Capital reserves are an important part of a company’s financial structure, providing flexibility and resilience in the face of economic challenges. They demonstrate a company’s commitment to long-term financial health and sustainable growth, which can be a positive signal for investors and lenders.