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 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 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.
|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 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 calculated 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 $)|
|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 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 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 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.