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.
- 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 therefore should not be used to evaluate the company's financial health.
- Capital reserves are reported on 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
A company may create a capital reserve 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.
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 does not include anticipated or long-term costs. The capital reserve is generally held in a company bank account or may be invested in high-liquidity securities.
The term capital reserve is anachronistic because the term “reserve” is not defined under generally accepted accounting principles (GAAP).
Companies may keep a capital 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 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.
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 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 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.