What are revenue and capital reserves?

To build a successful business, you need to be ready for the unexpected—and your cash and capital reserves help you do this.

But it’s easy to get confused by the sheer volume of terms and calculations in reserve accounting.

This article explains how keeping reserves can help small and medium-sized businesses, and how they work.

Overview of reserves

Think of your reserves as like the suspension in a car, smoothing out bumps in the road and stopping the wheels falling off.

Keeping some of your profits in reserve, rather than paying them out as dividends immediately, enables you to cover unplanned costs when they arise and avoid dipping into salaries or cutting dividends later.

This will help you cover smaller daily upsets such as repairing a broken machine, or legal fees around a dispute. But if you save enough, reserves will also help you stay afloat in difficult financial times, say if you have a few lean months or even years due to a pandemic or financial crisis, for example.

Keeping reserves helps in many other ways too. Business owners often make the mistake of spending surplus profits in an unplanned or undisciplined way. Keeping reserves helps you focus on your business’s needs.

For example, you can use reserve accounts to ensure money remains available for reinvestment in growth, or productivity or efficiency improvements. This can ultimately impact your long-term profitability, scale and agility.

Andrew Shepperd, co-founder of Entrepreneurs Hub, says: “Although you can use all your retained profit to pay dividends, we always recommend leaving headroom in reserves for unexpected future losses, which could make your business insolvent.

“You may also want to re-invest some retained profits to enable growth by buying fixed assets or working capital, rather than borrowing money to do so.”

Another consideration is your credit rating, adds Andrew. If you have low reserves or they decline significantly due to dividends being higher than profit after tax, that may alarm some credit rating agencies.

Revenue reserves and how businesses use them

Accountants and business advisers use various phrases such as “company reserves”, “revenue reserves”, “capital reserves”, and “capital and reserves”.

Here’s an explanation of how companies and their advisers typically use each phrase in practice.

Revenue reserves are sometimes called profit and loss reserves, general reserves or retained earnings.

The Institute of Certified Bookkeepers’ defines (distributable) revenue reserves as the net profits you set aside after paying dividends.

Doing this creates a general cash buffer for unexpected items or difficult financial periods.

Healthy revenue reserves can also enable you to:

• Pay suppliers and replenish your working capital so you can run everyday operations without hiccups
• Self-finance reinvestment in the business without having to borrow or dilute ownership by bringing in other investors
• Smooth dividend payments over time, which should support long-term success by establishing a positive relationship with shareholders.

Catherine Heinen, technical content writer at TaxAssist Accountants, says: “We often explain to clients that, should they have a difficult period, sufficient cash reserves ensure they can continue to declare dividends and meet their payment obligations, which may include loans and staff wages.

“When reserves are negative, it can be a sign your company is in poor health.

“Furthermore, a prospective shareholder may use the reserves balance to gauge whether to invest in your company, among other calculations.”

Alongside a general reserve account, you can allocate your retained profits for specific future costs, such as buying new premises or machinery, repaying debts, funding legal costs or expansions, and paying employee bonuses or future dividends.

To do this, set up appropriately labelled reserve accounts in your balance sheet – for example, a “Debt Reserves Account” for money you want to earmark for paying off loans. It can be helpful to create a dedicated label in your accounting system, and even put this money into a separate account.

Another tip for safeguarding these assets is to create criteria that must be fulfilled before they can be used. This could include all chief business owners, or even all investors, having to sign it off.

You may also want to treat your general reserves as a fixed expense, so you add to them regularly and avoid using the money to pay for non-core business items.

How to account for revenue reserves

There are no legal restrictions on the use of reserves funded from profits. You can use them for any purpose.

While it can be tempting to treat this money as working capital, it’s a good idea to allocate and report reserves on your balance sheet. This gives board members, investors, or even potential buyers, a clear picture of the company’s financial health, and how it intends to use the money.

Reserves are entered on a balance sheet as liabilities because they are money kept aside to pay for things in the future.

To calculate your revenue reserve, add up your cumulative profit and loss since you formed the business, minus any dividends paid.

You can leave revenue reserves in your retained earnings account.

But if you want to allocate it to specific purposes, set up a designated reserve account, then simply transfer an amount from your retained earnings to the designated account.

Debit retained earnings for the segregated amount, and credit the designated reserve account for the same amount.

When you’ve completed the designated activity, reverse the entry by debiting the reserve account and crediting retained earnings.

For example, say you want to reserve £1m for a future construction project, create and credit a ‘building reserve account’ for £1m and debit your retained earnings for the same amount. Once the building is finished, reverse the original reserve entry, with £1m debited to the building reserve fund and the same amount credited to retained earnings.

What are reserves from capital gains?

Capital reserves are a different type of company reserve.

They are rarer for businesses and only arise from capital gains from specific transactions such as premiums from a share sale, sale of assets, and revaluations. They may be referred to on your balance sheet as simply the Share Premium Account and Revaluation Account, for example.

An example of a revaluation is if a building was initially bought at £200,000 but revalued at £250,000—that would create a revaluation reserve in your accounts of £50,000.

According to the ICB, while reserves from profit can be used for any reasonable purpose, including divided payments, capital reserves have far more stringent laws around usage.

For example, you can’t use share premium reserves to pay dividends or offset trading losses. However, you can use them for buying back company shares.

Businesses typically do use capital reserves by putting them aside to balance any future asset losses – that is, when the values of assets, such as property or investments, fall. But if you sell an asset, such as a building, for more than you paid for it, this could constitute a profit-making activity. So it may be possible to distribute the proceeds as dividends or use them for other purposes.

What is “capital and reserves”?

Another phrase you may come across is “capital and reserves” which, confusingly, is a different thing to “capital reserves”.

Catherine explains that capital and reserves is also referred to as equity—the amount owners would keep if they sold their shares in the business—and is represented at the bottom of the balance sheet.

Capital and reserves include your share capital and share premium account, accumulated retained earnings and revaluation reserve, she says.

Final thoughts: Controlling reserves tightly is the key to success

Don’t underestimate the need to keep reserves in your company and account for them carefully.

In uncertain times, you must be primed for the unpredictable at all times.

Keeping allocated reserves could be the difference between high or low efficiency and productivity, growth or stagnation, or even between survival or failure.

Keeping a close eye on your reserves ensures you have enough to deal with any eventuality, and accounting for reserves carefully ensures transparency so your stakeholders understand your financial position and intentions.

As your business grows, accounting for reserves can become increasingly complicated and smart accounting software will be essential.