Revenue reserves otherwise known as your distributable profits are the profits your business has made over the years which it has yet to distribute as dividends.
It is the weapon cache for any business because the stronger your revenue reserves the stronger the ability of the business to fund new opportunities for growth which result in profits and then increases your reserves yet again. It is the financial equivalent of nuclear stock piling.
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Companies with impressive reserves are mostly associated with higher price valuations as investors see the reserves as cash that can be used to fight off competition. It can also be used to pay dividends to shareholders during the periods of low profits or even losses. This is because a company with a positive revenue reserve can pay dividends even if it made losses in that year and can’t pay dividends if it has no negative reserves that cannot be covered by the profits it just made.
Revenue reserves also gives me an idea of how well a company has been able to increase its return on equity during a particular year. For example, if a company has N100million in its reserve in year 0 and then goes on to make N30million in profit after tax for the year under review one can effectively say the company made an ROI on its retained earnings of 30%.
Opportunity Cost of ROI
An investor would want to compare the opportunity cost of that ROI with how much they would have made on their own had the money distributed to shareholders. Thus if the company has made an ROI of just 5% then you can as well assume they performed poorly with your money despite making profits.
By looking at the percentage of your revenue reserves against your total equity one can easily determine if the company has constantly made money for shareholders by reinvesting profits rather than asking for new equity or borrowing from banks. However, a high dividend paying company may also have lower revenue reserves as a percentage of total equity.
Revenue reserves can also be represented on a financial statement in the form of assets or cash. If it is represented in the form of assets, then you might want to know how quickly such assets are generating profits using the return on assets formula. Revenue reserves can also be presented as cash, meaning the company is yet to convert or invest it into operating assets.
Whilst investors love to see cash, no one likes to see it lie idle for too long, for fear of been eaten up by inflation. That is why Apple was recently heckled by protesting shareholders who thought the company should either be returning its over $100billion in cash to shareholders as dividends or invest it in building new products.
So, next time you pick up the results of a company go to the balance sheet section to see how strong and influential the reserve is.
BEWARE: This story was earlier published in 2013 and has just been revamped for public education –on July 24, 2019.