What Is a Capital Reserve?
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 is derived from the accumulated capital surplus of a company and is created out of its profit.
The term capital reserve also is used to describe the capital buffers that banks are required to establish to meet regulatory requirements and can be confused with reserve requirements, which are the mandatory cash reserves the Federal Reserve requires banks to maintain.
- A company's capital reserve is the cash reserved for unexpected short-term expenses.
- An adequate capital reserve would be three to six months' worth of business expenses.
- A company's capital reserve is not derived from its operations and therefore should not be used to evaluate the company's financial health.
Understanding Capital Reserve
A company's capital reserve may be created through a variety of transactions including selling fixed assets, the upward revaluation of assets to reflect their current market value, issuing stock in excess of par value (share premium), profits on the redemption of debentures, and the reissue of forfeited shares.
That is, a capital reserve is created through capital profit, not through the company's everyday business.
The purpose of maintaining a cash reserve is to allow a company to meet unexpected short-term costs without taking on expensive debt. It does not include anticipated or long-term costs. The capital reserve is generally held in a company bank account.
The term capital reserve is anachronistic because the term “reserve” is not defined under generally accepted accounting principles (GAAP).
Capital reserve may be used for unexpected
How Much Is Enough?
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 may include long-term projects, mitigating capital losses, or other contingencies.
A capital reserve is created out of non-operating activities and is unrelated to the company's stock performance or the company's operational activities. Therefore, it cannot be used as an indicator of the operational health of a business.