What it means
Equity is not one undifferentiated block. Retained earnings come from trading and can usually be distributed, whereas capital reserves come from capital transactions and are normally locked away by law or accounting rules.
The classic sources are worth memorising. Share premium arises when shares are issued above their nominal value, revaluation reserves arise when assets are restated upwards, and capital profits arise when a fixed asset is sold for more than its carrying amount.
The purpose is protection rather than performance. By keeping these amounts out of distributable profit, the rules stop a company from paying away money that represents either shareholder contributions or unrealised value, both of which creditors are entitled to see standing behind their debt.
Permitted uses are narrow and vary by jurisdiction, but commonly include issuing bonus shares, writing off share issue expenses and absorbing capital losses. What a capital reserve cannot normally do is fund an ordinary dividend.
The nuance that trips people up is the difference between a capital reserve and a general reserve. A general reserve is simply retained profit that management has earmarked internally, so it remains distributable, whereas a true capital reserve is restricted by the rules themselves.
Anyone reading a balance sheet should therefore look inside the equity section rather than at the total. Two companies with identical equity can have very different dividend capacity depending on how much of that equity sits in restricted capital reserves.
In practice
Real-world examples.
Example
A logistics firm sells a depot it has owned for twenty years for $950,000 against a book value of $600,000. The $350,000 capital profit is credited to a capital reserve rather than boosting distributable retained earnings. The cash is real, but the rules stop it being paid straight out as a dividend.
Example
A growing technology company raises funds at $3 per share on $1 nominal shares. The $2 per share premium builds a $1,000,000 capital reserve that later funds a one-for-four bonus issue to existing shareholders.
Example
A property investment company revalues its portfolio upwards by $4,200,000. The gain sits in a revaluation reserve, and the finance director has to explain repeatedly that the higher equity figure cannot be paid out as a dividend.
Formula
Calculation
Capital reserve balance = Opening balance + Capital profits credited - Amounts applied
A company completes two capital transactions during the year. It sells a surplus parcel of land with a book value of $600,000 for $950,000, and it issues 500,000 new ordinary shares with a nominal value of $1 each at a price of $3 per share.
Capital profit on the land = $950,000 - $600,000 = $350,000
Share premium = 500,000 x ($3 - $1) = 500,000 x $2 = $1,000,000
Total credited to capital reserves = $350,000 + $1,000,000 = $1,350,000
The company then applies $200,000 of the share premium to write off the professional fees and underwriting costs of the share issue, which is a permitted use. The closing capital reserve is therefore $1,350,000 - $200,000 = $1,150,000, none of which is available for dividends.Case study
Seen in the real world.
Marchwood Logistics is a fictional haulage and warehousing company used here only as an illustrative example. During one year it sold a redundant depot with a $600,000 book value for $950,000 and separately issued 500,000 shares of $1 nominal value at $3 each.
The two transactions added $350,000 of capital profit and $1,000,000 of share premium, giving $1,350,000 of new capital reserves. Two shareholders promptly asked for a special dividend, having seen equity jump on the balance sheet. The finance director explained that these amounts were capital reserves, not trading profit, and were restricted.
In the illustrative outcome Marchwood used $200,000 of the share premium to write off the issue costs, leaving $1,150,000, and later applied part of the balance to a bonus issue. Shareholders received extra shares rather than cash, which satisfied the desire for a reward without breaching the distribution rules.
Watch out
Common mistakes.
- Treating a capital reserve as spare cash. It is an equity classification, not a bank balance, and the underlying money may already be tied up in assets.
- Confusing a capital reserve with a general reserve. A general reserve is earmarked retained profit and stays distributable, while a capital reserve is restricted by law.
- Running a revaluation gain through the income statement. Unrealised revaluation surpluses belong in a reserve within equity, not in reported profit.
Questions
People also ask.
Can a capital reserve be used to pay dividends?
Generally no, because these amounts are restricted; only realised trading profits in retained earnings are normally distributable.
What can a capital reserve actually be used for?
Common permitted uses include issuing bonus shares, writing off share issue expenses and absorbing capital losses.
Does a capital reserve mean the company is financially strong?
Not necessarily, since a large revaluation reserve can sit alongside weak cash generation and heavy borrowings.
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