Reserve capital

From CEOpedia | Management online

Reserve capital is one of the capital existing in companies (we can find them in company like joint-stock company or limited liability company. This is a part of own capital which is created by:

  • Specific reserves
  • In case of individual collect resources by owner of companies (so - called discretionary reserves)
  • In a moment when composition of the balance sheet is changing and value of them
  • When the sales profit is higher than them normal value

Reserve capital is really important because this may be using in the crisis moment of company. In this kind of situation the owners very often have to use foreign capital for example bank credit or loan. This capital could be also using in a lot of different way. For example, use them to spend on development of company. All decisions related with the use of this capital are made on meeting of shareholders. As bigger is the reserve capital than risk of undesirable effects is lower[1]

Reserve capital is very often mistaken for supplementary capital but in practice this is other kind of capital. In supplementary capital transferred is nothing less than 8 percent of profit which has been achieved for whole financial year. The exception is situation when this capital is equal or bigger than 1/3 of whole company capital. General assembly of shareloaders make decision how to use both reserve and supplementary capital. Although what is very important, cash from reserve capital which is approximately 1/3 of company capital, can be used only for cover loss which was show in financial report of this company. In situation where management prepare balance sheet which shows loss bigger than summary of company capital and supplementary capital and 1/3 of whole capital of company, the management is obligated to convene of general meeting of shareloaders to decide about existence this company in future. So, in practice the supplementary capital is using to cover losses in company, and reserve capital is destined to mostly on development of company. The common feature capitals presented above is fact that both is mandatory in limited liability company.

Reserve capital in banking

In the bank area the reserve capital shall be considered as capital buffer. All kind of financial institution like for example bank are obliged to preserve financial impact. For this reason they must have sufficient financial resources to cover financial losses and stay afloat in the event of crisis or something other situation which revenues are lower than needed. In the case when ones of bank is insolvent, this could be flounce of all of financial system. In this situation we are make sure that close this bank will not cause a "chain reaction".[2]

All banks are obligated to have minimum two kinds of financial buffer: the countercyclical capital buffer and capital conservation buffer. This meaning that this banks are obligated to have enough big own capital which can redeem losses in case of money problems. Apply buffers can reduce a financial requirements[3]

First buffer (countercyclical) is intended to reduce impact between economic cycle and the credit activity of this bank. In the periods of good prosperity banks have to collects the greatest possible supply of capital to in periods of poor state can use them to protect lending activities. When bank doesn't have this buffer, must proceed as in the case lack off capital conservation buffer.

Second buffer (conservation) is obligated banks to have enough big capital stock to preserve whole banks capital of this bank. If some bank doesn't have this buffer is forced to stop or reduce payment of all bonuses and dividends.

Difference between reserve capital and capital reserve

At the end we must remember that reserve capital is not the same as capital reserves. The reserves of capital protect bank against negative proceed of economy processes. This reserves are long-term and may be invested at the option. They are part of own capital, collect by the owners and they are not mandatory in opposite of reserve capital.

Examples of Reserve capital

  1. Retained Earnings: Retained earnings are the portion of a company's net income that is not distributed as dividends to shareholders but instead is reserved for reinvestment in the business. This is the most common form of reserve capital.
  2. Paid-in Capital: Paid-in capital is the portion of a company's capital that is contributed by shareholders in exchange for shares of the company's stock. Paid-in capital is recorded on the balance sheet as an increase to shareholders' equity and represents the amount of money invested in the company by shareholders.
  3. Reserves: Reserves are portions of a company's net profits that are reserved for special purposes, such as the repayment of debt. A company may also establish reserves for future expansion or to cover unexpected losses.
  4. Preferred Stock: Preferred stock is a type of capital stock that pays a fixed dividend to its holders. The dividend is paid before dividends are paid to common stockholders. Preferred stockholders also have priority in the event of a liquidation of the company.
  5. Treasury Stock: Treasury stock is the portion of a company's shares that have been issued but subsequently reacquired and held by the company. The company can use treasury stock for various purposes, such as to satisfy future share option grants or to use for a stock buyback program.

Advantages of Reserve capital

Reserve capital is one of the capital existing in companies like joint-stock company or limited liability company. This is a part of own capital which is created by shareholders and is used for the purpose of covering potential future losses. There are many advantages of reserve capital, such as:

  • Reserve capital ensures financial stability and soundness of a company. It can be used to cover losses, liabilities and other unexpected expenses, which can help the company to remain solvent and competitive.
  • Reserve capital can also be used to invest in new projects or to make strategic acquisitions, which can help to generate higher profits and increased market share.
  • Reserve capital can help the company to protect itself against inflation. By investing in long-term assets, the company can maintain its purchasing power and reduce the impact of inflation on its finances.
  • Reserve capital can also help the company to attract new investors, as they will be able to see that the company is well-funded and is able to cope with unexpected losses. This will increase their confidence in the company and encourage them to invest.

Limitations of Reserve capital

Reserve capital is an essential part of a company's capital and is created through various means. However, there are some limitations to reserve capital that should be taken into account. These limitations include:

  • Reserve capital is not allowed to be distributed to shareholders as dividends, as it is reserved for future use.
  • Reserve capital is also limited by legal restrictions, such as the company's articles of association. For example, some companies may set a limit on the amount of reserve capital that can be accumulated.
  • Reserve capital is subject to fluctuation due to changes in the market, or due to other external factors. Therefore, it is important to ensure that the company has enough reserve capital available to cover any potential losses.
  • Reserve capital should not be used for any purpose other than for the company's intended purpose, as this could lead to legal and financial repercussions.

Other approaches related to Reserve capital

One of the approaches related to Reserve capital is to use it as a buffer against unexpected losses, as it can help to cover the losses in difficult times. Other approaches to Reserve capital include:

  • Investing it in stable financial instruments such as bonds, stocks, and mutual funds to generate income;
  • Setting aside a portion of the reserve capital for emergency situations, such as natural disasters or market downturns;
  • Utilizing the reserve capital to fund capital expenditures or capital improvements for the company, such as purchasing new equipment or renovating facilities;
  • Allocating the reserve capital to pay down debt or increase equity;
  • Using the reserve capital to pay out dividends to shareholders.

In summary, Reserve capital is an important tool that can be used to help companies protect themselves against unexpected losses, generate income, and fund capital improvements. It can also be used to pay down debt, increase equity, and pay out dividends.


Reserve capital — recommended articles
Debenture Redemption Reserve — Appropriation of retained earnings — Free Reserves — Revenue reserve — Non current liability — Capital Base — Capital buffer — External sources of finance — General reserve

References

Footnotes

  1. ↑ Eberlein E., Madan D. B. (2010)
  2. ↑ Freixas X., Bruno M. Rochet P. J. (2000)
  3. ↑ Repullo R., Salas J. S. (2011)

Author: Justyna Chłopek

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