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Capital Surplus and Reserves

Investing Lesson 3 - Analyzing a Balance Sheet


Capital Surplus and Reserves

A company doesn't actually set aside cash in an account. Instead, management charges the cost off as an expense on the income statement. You can't "dip into" the depreciation reserves because they are accounting entries. There's no money there.

Capital Surplus

To understand what Capital Surplus is, you must first understand the concept of Surplus. From an accounting standpoint, surplus is the difference between the total par value of the stock outstanding and the shareholder equity and Proprietorship Reserves. (Don't panic! It's not as complicated as it sounds!) You already know what par value and shareholder equity are. The only thing you haven't learned about is Proprietorship Reserves, which we will discuss in a minute.

Almost always part of the surplus is a result of retained earnings (which would increase the shareholder equity). There is a specific part of the surplus that comes from other sources (such as increasing the value of fixed assets carried on the balance sheet, the sale of stock at a premium, or the lowering of the par value on common stock). These "other" sources are frequently called "Capital Surplus" and placed on the balance sheet. In other words, Capital Surplus tells you how much of the company's shareholder equity is not due to retained earnings.

Reserves & Proprietorship Reserves

Reserves deserve special attention when analyzing a company. Although we aren't going to discuss them in depth until a later lesson, it would be wise to lightly touch on them so you have a general understanding of their purpose. When a business creates a "Reserve", they are essentially setting aside a certain amount of money for a specific purpose. Often times, reserves are monies set aside to act as a buffer against future losses. Let's look at a few examples:
  • If a company had a substantial amount of their current assets in accounts receivables, they would set charge off a percentage of the total amount they were owed in case some of the customers didn't pay their bills. This is a reserve for doubtful and bad accounts.
  • If a business had a build up of inventories that risked losing their value, management would create a reserve to offset losses.
  • If a manufacturing corporation decided to save money to build a new widget plant, they would put money in a reserve until they had saved enough to pay for it. In this case, there would be no accounting entry, just a pile of cash growing on the balance sheet.

Proprietorship Reserves are set up to alert investors that a certain part of the shareholder equity cannot be paid out as cash dividends since they have another purpose.

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This page is part of Investing Lesson 3 - Understanding the Balance Sheet. To go back to the beginning, see the Table of Contents. If you have already read this lesson, you can skip directly to the Balance Sheet Quiz.

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