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Revenue reserve helps a business become fundamentally strong. The reserves are used for meeting contingencies and for business expansion. When an organisation starts generating a fair amount of profits, they tend to establish a reserve that holds a portion of their profit and could be used in the future to meet business requirements. Businesses distribute their revenue reserves in the form of bonus stock issues. Let us dive deeper to understand revenue reserves, their advantages and why businesses need to implement such activities today.
What is meant by revenue reserve?
The savings kept aside from the earnings to satisfy the organisation’s needs are called reserve accounting. A reserve is the saved money kept aside and used when needed, i.e., earnings that are kept aside for a specific reason.
For example, if an owner wants to buy assets such as machinery for more production, they can dip into the reserves. In addition, reserves can be helpful to invest in some other prospect. However, if the owner spends the reserve outside the firm, it is known as reserve funds. The company retains these reserves so that the organisation is secure and has good financial standing.
How are reserves created?
The board of directors has the authority to create a reserve. They are created from earnings by the core operations for any future use. Furthermore, the funds designated for reserves can be used for any purpose. For recording reserves, retained earnings are debited from the reserve account, and when the activity is completed, the money is moved back to the retained account.
Why should companies have revenue reserves?
Since revenue reserves help make a business stable and fundamentally strong, they are beneficial for shareholders. When a business makes a surplus profit, some amounts are distributed as dividends, and the rest is kept in the form of revenue reserve and can be reinvested. These reserves are indirect measures of operational efficiency. These revenues are never shown on the books as they are made up and prepared from the actual profit. More the amount, the more beneficial for the shareholders.
Advantages of Revenue Reserves
There are certain benefits of reserve revenue:
It is an excellent source of internal finance.
It can be used to meet short-term business requirements.
It can also be distributed to stakeholders.
It can be used to replace old assets or pay an urgent liability.
It helps in improving operational productivity.
Difference between Revenue Reserve and Capital Reserve
Revenue Reserve | Capital Reserve |
Revenue reserve refers to the sum of money kept aside by the organisation to meet any future contingencies. | Capital reserve refers to the fund created for a long-term project or to write off capital expenses. |
The main source for this reserve is through firm profits. | The main source of capital revenue is through the capital profit of the firm. |
These reserves are used to meet any unforeseen contingencies. | These reserves are used to adhere to any statutory requirements. |
It can be used for any or a particular reason. | It is only used for the purpose it was created. |
It is freely available to distribute as a dividend. | It is not available to distribute as dividends. |
Operating Efficiency and Revenue Reserve
There is no relationship between operating efficiency and the retention ratio. However, the company can retain more net profits if they are worth the attention. If we see the ratio between net profit and total capital employed, we can get a clear idea about the organisation’s operational efficiency. For example, if the firm has a revenue reserve of US $100,000, then the net profit could be US $400,000. Here, the revenue reserve is an indirect indicator of the organisation’s efficiency.
Dividends and Revenue Reserve
The investments made in the stock market have two ways of providing returns. They are via dividend payments or through capital appreciation. The only power one has as a stakeholder is to approve or reject the dividend payments. The other important decision regarding dividends is whether to pay them in cash.
Revenue reserve is the cumulative profit of the company from previous years and also from the most recent profitable year.
Dividend payments are paid out from distributable profits.
You can find revenue reserves under the column of shareholder funds mainly stated after Issued Capital or Share Premium from the financial statement.
Conclusion
In a nutshell, creating reserves is necessary for the organisation to safeguard itself from any unforeseen losses or contingencies that might arise in the future. It can also be used to strengthen the business’s financial position and redeem its long-term debts. Companies can use these reserves to pay dividends, pay off external debts and profit from diverse portfolios.
