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What are Capital Reserves?
Capital Reserves are funds set aside from a company’s profits or capital surplus to strengthen its financial position, absorb future losses, or finance long-term projects. Unlike revenue reserves, capital reserves are not created from normal operating profits but from capital-related transactions.
Definition
Capital Reserves are reserves generated from capital transactions (such as share premiums, asset revaluations, and profits on the sale of fixed assets) that are retained for long-term financial stability rather than distribution as dividends.
Key Takeaways
- Created from capital—not operational—activities.
- Strengthens a company’s financial structure and risk buffer.
- Generally not available for dividend distribution.
Understanding Capital Reserves
Capital reserves originate from transactions that do not arise from day-to-day business operations. They represent a portion of shareholders’ equity and are used strategically to:
- Absorb unexpected financial losses
- Support future expansion or acquisitions
- Improve the company’s balance sheet health
Common sources of capital reserves include:
- Share premium received on issuing shares above par value
- Profit from the sale of fixed assets
- Revaluation surplus on upward asset revaluation
- Redemption of debentures at a discount
These reserves reflect long-term financial strength, improving investor confidence and creditworthiness.
Formula (If Applicable)
No single formula exists, but capital reserves typically include:
Capital Reserves = Share Premium + Revaluation Surplus + Capital Profits
The exact composition depends on jurisdiction and accounting standards.
Real-World Example
A company issues shares at $12 each when the par value is $10. The extra $2 per share becomes share premium, contributing to the capital reserve.
If the company later sells a piece of land at a profit of $500,000, that profit (being capital in nature) also adds to the capital reserve.
This reserve strengthens the company’s financial base for future capital expenditure.
Importance in Business or Economics
Capital reserves play a vital role in:
- Increasing financial stability
- Funding capital-intensive projects
- Improving leverage and shareholder equity
- Enhancing the company’s risk management capacity
They serve as a cushion during economic downturns and support long-term sustainability.
Types or Variations
- Share Premium Reserve: Extra funds from issuing shares above par value.
- Revaluation Reserve: Gains from revaluing assets.
- Capital Redemption Reserve: Created when redeeming shares or debentures.
- Asset Disposal Reserve: Gains from selling capital assets.
Related Terms
- Revenue Reserves
- Share Premium
- Revaluation Surplus
Sources and Further Reading
- IFRS Accounting Standards: https://ifrs.org
- Corporate Finance Institute: https://corporatefinanceinstitute.com
- Investopedia: https://investopedia.com
Quick Reference
- Capital reserves arise from capital transactions.
- Not typically available for dividends.
- Strengthen long-term financial structure.
Frequently Asked Questions (FAQs)
Are capital reserves the same as revenue reserves?
No. Revenue reserves come from operating profits, while capital reserves originate from capital transactions.
Can capital reserves be used to pay dividends?
Generally no. Most jurisdictions restrict dividend payments from capital reserves.
Why do companies maintain capital reserves?
To reinforce financial stability, support long-term projects, and manage future uncertainties.
