Table of Contents

What Is a Capital Reserve?

By 澳洲幸运5官方开奖结果体彩网:Alicia Tuovila

Updated July 30, 2024

Reviewed by

Thomas Brock

Fact checked by

Jiwon Ma

Definition

Capital reserves are cash set aside for unexpected expenses or losses.

A capital reserve is a line item in the equity section of a company's balance sheet that indicates the cash on hand that can be used for future expenses or to offset any capital losses. It's derived from the accumulated capital surplus of a company and is created out of its profit.

The term capital reserve is also used to describe the capital buffers that banks must establish to meet regulations and can be confused with 澳洲幸运5官方开奖结果体彩网:reserve requirements, which are the mandatory cash reserves the Fꦫederal Reserve requires banks to maint𝓰ain.

Key Takeaways

A company's capital reserve is the cash reserved for unexpected short-term expenses.
Depending on the business, an adequate capital reserve might cover three to six months' worth of business expenses.
A company's capital reserve is not derived from its operations and so should not be used to evaluate the company's financial health.
Capital reserves are reported in the equity section of the balance sheet.
Companies may invest their capital reserves in low-risk securities, allowing them to earn a small amount of interest.

Understanding Capital Reserve

Companies create capital reserves through a variety of transactions, including selling fixed assets, increasing the valuation of assets to reflect their current market value, issuing stock more than par value (澳洲幸运5官方开奖结果体彩网:share premium), profit🤪s on the redemption of debentures, and the reissue of forfeited shares🍬.

In other words, a capital reserve is created through capital profit, not through the company's everyday business.

The purpose of a cash reserve is to allow a company to meet unexpected short-term costs without taking on expensive debt. It doesn't include anticipated or long-term costs. The capital reserve is generally held in company bank accounts or may be invested in high-liquidity securities.

The term capital reserve is anachronistic because the term “reserve” is not defined under 澳洲幸运5官方开奖结果体彩网:gener🐬ally accepted accoജunting principles.

Fast Fact

Companies 𝐆may keep a capit𒆙al reserve for unexpected expenses or obligations.

Requirements for a Capital Reserve

A "solid" cash reserve, according to financial advisers, might be equal to three to six months of company ordinary expenses.

Sums allocated to a capital reserve are invested long-term and cannot be used to pay dividends꧅ to shareholders. They are earmarked for specific purposes, which m💦ay include long-term projects, mitigating capital losses, or other contingencies.

A capital reserve is created out of nonoperating activities and is unrelated to the company's stock performance or the company's operational activities. Therefore, it shouldn't be used to indicate the operational health of a business.

Capital Reserve Example

Company A sells some machinery it no longer ne🅷eds. The $40,000 proceeds are reflected on its balance sheet as a liability under reserves, where money set aside to pay f❀uture obligations is listed.

The company plans to use this $40,000 specifically to cover refunds. It parks the money in a highly liquid savings account. That way, it can earn i🍸nterest on the balance and make withdrawals at any time, as and when the money🎃 is needed, without giving notice or paying financial penalties.

As🔥 refund reqꦫuests arise, the company reduces the $40,000 reserve on its balance sheet.

Below are other major terms to know when reading a company's balance sheet:

How Do Businesses Invest Their Reserves?

The simplest way for a business to invest its unneeded cash reserves is to store the excess in a savings account, where it will earn a small amount of interest. Companies with more substantial reserves may invest them in money market instruments or other 澳洲幸运5官方开奖结果体彩网:cash-equivalent securities for extra interest.

How Do You Account for Capital Reserves on a Balance Sheet?

On a financial statement, capital reserves or other surplus capital should be listed in the section under "shareholder equity." This reflects the fact that these assets can be used for future expenses or unexpected losses.

How Do Companies Raise Capital?

The simplest way for a company to 澳洲幸运5官方开奖结果体彩网:raise capital is by ✱selling equity, either🌄 through a private placement to select investors, or by selling shares in a public offering. They can also raise capital by borrowing money or selling bonds. In a pinch, a larger company can also raise funds by selling their assets, such as unused property or even a corporate subsidiary.

The Bottom Line

A capital reserve is cash set aside by a company generally to cover unexpected expenses or losses. It is created through capital profit, rather than through the company's everyday business, and is earmarked to help companies meet unexpected short-term costs without having to take on expensive debt.

Capital reserves cannot be used to pay dividends, should not be used to check a company’s financial health, are typically invested in high-liquidity securities, and are reported in the equity section of the company’s balance sh💞eet.

Article Sources

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U.S. Securities and Exchange Commission. “.”
European Central Bank. “.”
Na😼tional C♑redit Union Administration. “,” Pages 16-17.
Board of Go🐓vernors of the Fede🍃ral Reserve System. “.”

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