Capital reserve: what it is and its importance for companies

Understand the importance of having a financial reserve to deal with unforeseen events and as a source of extra income.

According to research data from  FGV, more than half of micro and small companies do not have a capital reserve. And in emergency or unforeseen situations, they resort to indebtedness by making bank loans.

This reserve is not just a privilege for large companies, if it is well planned it can be applied to any size and type of business. For better financial health of your company, find out what this capital reserve is, how it works and how to use it in the next topics.

What is capital reserve?

The capital reserve is a financial reserve of a company, but it differs from the profit reserve. It is an insertion of capital that has no relation to the revenue generated in the company.

The profit reserve is the separation of part of the profits generated by the revenue of a business and integrates the share capital. The legal profit reserve corresponds to 5% of net income for a fiscal year limited to 20% of the company’s share capital . It must be separated before the distribution of profits among shareholders. This reserve can also be used for contingencies, cover losses and investments.

Knowing some basic accounting concepts helps to understand the concept of capital reserve. It forms part of the company’s equity , which includes assets and liabilities. It is a contribution of resources injected into the business capital, but not necessarily from own resources, it can also come from donations, government tax incentives and share premium.

Companies that don’t have a capital reserve can go into despair or even close their doors because they don’t have resources to use in unforeseen circumstances. In times of inflation and high inputs, the reserve can be the salvation to keep the business in financial health. It can be used to pay off debts and reduce expenses with bank interest payments.

Understand the importance of capital reserve for a company

But what is the importance of having a capital reserve in a company? Its main function is to be an emergency reserve to be used in specific situations of crises, pandemics and facts that threaten the financial health of a business.

It can be used to replace financial losses when profitability declines and maintain the company’s stability and vitality. An example was the 2020 coronavirus pandemic, in which there was social isolation and not all companies were prepared for digital sales or delivery. In this case, whoever had a capital reserve used it. Those who didn’t had more problems or even went bankrupt.

It is a solution to avoid bank loans and unnecessary debt. The reserve amount can be applied to investments with high liquidity for quick use in emergency situations.

How does the capital reserve work?

The shareholders or the source of external resources make the capital available for the company’s financial reserve. However, there is no obligation of rendering accounts or consideration for the receipt of this capital.

Thus, this reserve can be applied to specific projects, to cover losses or any activity of interest to the company. It can also be used to pay priority shareholders with fixed dividend rights in case of suspension of profit distribution to maintain the financial health of the company.

Another possibility is to avoid mass layoffs or closing the company in crises, being able to use this reserve to pay salaries or cover unforeseen expenses. That is, the main function is to keep the company running without debt.

For better financial management and use of the capital reserve, check out some tips:

• Gather all fixed and variable expenses;
• Check debts and negotiate rates with the bank;
• Analyze how much you need to gather as a capital reserve. A reference is to have a reserve that covers 6 months or 1 year of monthly expenses to be used in any emergency.

An accounting consultancy is of great help in deciding the details of the capital reserve, how to apply it and what to use it for. Consult your accountant to assess the reality of your company and what can be done for better financial management.

How can the capital reserve be used?

The capital reserve has different usage options. In accounting terms, it is incorporated into the company’s capital or in the redemption of founders’ shares.

Another use is to cover losses when the profit reserve is not enough to keep the company out of the red zone.

For the purchase, redemption or reimbursement of shares, funds from the capital reserve may be used.

It can also be a source of income, applying that capital in some kind of financial investment. This amount will be applied generating income to be used when necessary.

This reserve can also be used to take advantage of an opportunity to expand business or encourage new partnerships and negotiations. Other uses:

• investments in machinery;
• equipment;
• modernization of infrastructure and software;
• anticipation of purchases of inputs;
• raw material.