What it means
A company's equity includes several different components. Share capital and the share premium account are generally locked in to protect creditors, while retained earnings and some other reserves can be used for dividends.
Distributable reserves are the pieces that can legally be paid out. The usual main component is retained earnings that have been realised, which means earned in cash or an equivalent.
Other reserves may also be distributable if they were created in a way the law allows, for example through a court-approved reduction of capital. A revaluation reserve, by contrast, normally cannot be distributed until the gain is realised.
The test is applied company by company, not to a group as a whole. A parent might show large consolidated retained earnings in its group accounts, yet the parent company itself may hold few distributable reserves, because the profits sit in its subsidiaries.
Getting the cash up to the parent to pay a dividend may need an internal dividend, a loan repayment or a capital reduction. Distributable reserves also shape key business decisions.
A company that wishes to buy back its own shares, pay a dividend or pay a large management charge needs to have enough of them. Companies planning acquisitions or restructurings often create extra reserves on purpose, because a lack of them can block a shareholder payout.
Finance teams therefore keep a running schedule of distributable reserves for each entity, adjusted for unrealised items and for any restrictions in loan agreements. The schedule is reviewed before every dividend and updated after any major transaction.
It is a simple tool that avoids expensive legal mistakes. Auditors and lawyers often review the position when a group reorganises.
Moving a business from one company to another, or inserting a new holding company, can change which entity holds the reserves. Planning this early avoids discovering a shortfall just before a dividend is due.
In practice
Real-world examples
Example 1
A holding company receives $2,000,000 of dividends from its subsidiaries and pays $1,500,000 to its own shareholders. The finance team checks that the holding company itself has at least that amount of distributable reserves before the board approves the payment.
Example 2
A manufacturer wants to buy back $3,000,000 of its own shares. The company secretary confirms that distributable reserves are $4,200,000, so the buyback is lawful and can proceed. The remaining $1,200,000 stays available for future dividends.
Example 3
A new group holding company is formed through a share exchange and starts with no distributable reserves at all. The advisers arrange a capital reduction, with court or shareholder approval where required, to create $10,000,000 of distributable reserves ahead of its first dividend. Without this step the new top company could not pass profits on to its owners.
Think of it
Think of distributable reserves like the money in your household savings jar that comes purely from your take-home pay after all bills are paid. Even if your house increases in market value, you cannot spend that paper gain at the grocery store until you actually sell the house.
Formula
Calculation
Distributable reserves = Realised retained earnings + Other legally distributable reserves - Unrealised amounts included in retained earnings
Suppose a company has retained earnings of $1,000,000, a distributable reserve of $250,000 created by an approved capital reduction, and $150,000 of unrealised gains on investments included within retained earnings. Distributable reserves = 1,000,000 + 250,000 - 150,000 = $1,100,000. Share capital and share premium of $800,000 are excluded because they are not distributable.Case study
Seen in the real world
Windermere Holdings is an illustrative, fictional group with consolidated retained earnings of $25,000,000. Its shareholders expected a $5,000,000 dividend, as in previous years, and could not see why the chief financial officer was hesitating.
The chief financial officer explained that the holding company's own balance sheet showed distributable reserves of only $1,200,000, because most profits had been earned and kept in the trading subsidiaries. The group accounts were not the right test.
The subsidiaries paid up dividends of $4,500,000 to the parent in the following weeks, after checking their own reserves. The illustrative group then paid the dividend, and the finance team introduced a quarterly schedule so that the cash and the reserves would be in the right place at the right time. Each subsidiary now confirms its own position before sending any dividend upwards.
Watch out
Common mistakes
- Using the group's consolidated retained earnings to decide whether a dividend can be paid, when the legal test applies to the paying company alone.
- Counting a revaluation reserve or other unrealised gain as distributable, which can make the dividend unlawful.
- Assuming that large cash balances mean large distributable reserves, when cash and reserves are different things.
Questions
People also ask
Are distributable reserves the same as cash?
No, because reserves are an accounting measure of equity, while cash is an asset, and a company can have one without the other.
Can distributable reserves be created?
Yes, in some jurisdictions a company can reduce its share capital or share premium by following approved procedures, which turns part of it into distributable reserves.
Do lenders care about them?
Often they do, because covenants may limit dividends and a lender will want to see that reserves cannot be paid out in ways that weaken the company.