Difference Between Capital Reserve and Revenue Reserve

A common term found in a company's balance sheet is capital. The amount set aside as reserves is significant because it reduces the company's reported profits. When a company earns a profit at the end of a financial year, a portion of it is usually retained within the business. This retained amount is reserved for future contingencies, growth, or other purposes. This portion is called capital, and it can be classified as either revenue reserves or capital reserves, depending on the source of the profit.

Reserves are vital for securing a company’s financial stability. They can be used for various purposes, such as business expansion, paying stable dividends, fulfilling legal obligations, handling unexpected expenses, improving economic health, and making investments. These reserves are shown on the liability side of the balance sheet under the category “Reserves and Surplus,” along with the capital. However, if a company incurs losses, reserves are not created. Let us understand more about these reserves, and the difference between capital reserve and revenue reserve:

What is a Capital Reserve?

A capital reserve is a fund created from a company's capital earnings. Companies build these reserves through various activities, such as selling fixed assets, revaluing assets to match current market prices, issuing shares at a premium, profits from redeeming debentures, and reissuing forfeited shares. The primary purpose of such a reserve is to cover unexpected, short-term costs without relying on costly debt. This reserve is held in company bank accounts or invested in high-liquidity securities.

An example of capital reserve is as follows: A company plans to construct a new building in the future, so it may start saving for this purpose without accumulating large sums or taking loans. The company might sell older offices or other assets to fund the building project. The proceeds from these sales form the capital reserve, which the company retains fully for its use rather than distributing to shareholders. This capital is solely for the company's projects, and shareholders cannot claim it.

What is a Reserve Capital?

The key difference between a capital reserve and reserve capital is their purpose and accessibility. A capital reserve is a portion of a company's profit set aside for specific purposes, such as funding new projects or investments. This reserve cannot be used for dividend distribution. In contrast, reserve capital is a particular amount that a company keeps aside to be used only in the event of liquidation. Let us understand better with the help of an example: 

Imagine a company, XYZ Ltd., that made a profit of ₹1,00,000 from selling an old property. However, the company anticipates a loss of ₹30,000 due to the depreciation of some machinery. To prepare for this loss, XYZ Ltd. decided to create a reserve of ₹30,000 from its profit, ensuring they are financially prepared to absorb the loss when the time comes. This amount is not available for dividend distribution, as it is earmarked for future contingencies.

What is a Revenue Reserve?

A revenue reserve is a sum designated as a fund for building up from the gross profit a firm makes in a year of operation. When a company has large profits, it sets aside some of these profits to put back into the business. This amount is set aside and is called the revenue reserve or “retained earnings.” Such funds are also retained for other requirements, such as investment requirements, expansion needs, or exigent circumstances.

For instance, ABC Ltd. is a manufacturing firm that has made reasonable profits over many years. ABC Ltd. ploughs back a certain level of earnings to revenue reserves which can be used in the future to boost the business's fortunes. ABC Ltd. has decided to extend its production line due to increased product demand. They did not borrow money for the expansion but reinvested their accumulated revenues and incurred no more debts. The company also established this reserve to easily conform to market requirements as it also enhanced the company’s financial stability and flexibility.

Difference between Revenue Reserve and Capital Reserve

The key difference between revenue reserve and capital reserve is that revenue reserve is created from a company's net profit. In contrast, capital reserve is a fund set aside from specific transactions like asset sales or issuing shares above par value. We have provided a tabular representation of the difference between revenue reserve and capital reserve:

Summing Up

Reserves are one of the most significant factors in a company’s financial health. They serve as buffers to future expansion, capital expenditure, and contingent liabilities. The primary focus of differentiation of capital reserves and revenue reserves is based on the sources of the fund and its application. These features of capital are built up during a particular type of operation – namely, during sales and purchases of assets and share offerings at a premium. Each reserve plays a vital role in managing a company’s vulnerabilities and leveraging a company’s strengths. But at the same time, their difference in such characteristics as liquidity, usage, and risk serves as evidence of potential divergences in the role of these instruments in securing the company’s financial future.

FAQs

What are the golden rules of accounting?

The golden rules of accounting are essential principles that guide the recording of financial transactions. These rules ensure consistency and accuracy in accounting records:

Rule 1: "Debit is what comes in, and credit is what goes out."

This rule can be applied to real accounts (tangible assets like furniture, land, buildings, machinery, etc.). When an asset comes into the business, it is debited, and when it leaves, it is credited.

Rule 2: "Credit the giver and debit the receiver."

This rule applies to personal accounts. When a person or entity gives something to the business, they are credited. The receiver, who benefits from the transaction, is debited.

Rule 3: "Credit all income and debit all expenses."

This rule applies to nominal accounts. All incomes and gains are credited, while expenses and losses are debited. This helps determine the business’s profitability by adjusting the capital accordingly.

What is a capital reserve?

A reserve formed from capital profits is known as a capital reserve. Generally, such profits include sales of fixed assets or the profit that results from the sales of shares. The primary use of a capital reserve is to establish the company’s need for more capital in case of certain occurrences, for instance, inflation, or for expansion of the business or undertaking new projects.

What is a revenue reserve?

A revenue reserve is created from a company's net profit during a financial year. Unlike other profits, this reserve is not distributed to shareholders as dividends. Instead, it is retained within the company to address future business needs. These reserves are generated from the business's regular, day-to-day operations.

What is a reserve?

A reserve refers to the retained earnings set aside by a company to improve its financial stability. These funds are used for various purposes, such as settling debts and credits, purchasing fixed assets, supporting company expansion, meeting legal obligations, making investments, and other plans.

Does SLR earn interest?

Unlike the Cash Reserve Ratio (CRR), in the Statutory Liquidity Ratio (SLR), banks earn interest from the government securities they invest in. All banks controlled by the Reserve Bank of India (RBI) are mandated to maintain both SLR and CRR.

Is revenue and capital the same?

No. Capital expenditures are significant, one-time investments in fixed assets that will contribute to generating revenue over an extended period. On the other hand, revenue expenditures refer to the regular, short-term costs incurred to maintain daily business operations.

Is SLR kept with RBI?

The Statutory Liquidity Ratio, or SLR, is the minimal deposit that commercial banks must have in the form of gold, cash, and other securities. These deposits are kept by the banks themselves rather than held with the Reserve Bank of India (RBI).

What is CRR, in simple words?

The Cash Reserve Ratio, or CRR, refers to the percentage of a bank's funds that must be held with the Reserve Bank of India in cash. CRR ensures that banks have sufficient cash on hand to meet the withdrawal demands of their depositors.