Understanding a company's financial health is crucial. Performing fundamental analysis helps identify multi-baggers and promotes value investing. As part of their assessment, several investors analyse reserves in the balance sheet to check a company’s financial stability.
Let us understand what are reserves in a balance sheet in detail and learn how to analyse them for making informed investment decisions.
What are reserves in a balance sheet?
It is a common corporate practice to set aside profits for general or specific purposes. These accumulated or set-aside profits are known as “reserves”. For example, a company may transfer 5% of its profits every year to general reserve.
As per the Indian Accounting Standards (AS), all companies must disclose their reserves on the liability side of the balance sheet. Usually, these reserves serve various functions and provide financial stability.
Let us have a look at some common types of reserves in balance sheet
General reserve
- These are also known as retained earnings.
- These reserves are:
- Accumulated over time from profits and
- Not distributed as dividends
- General reserves provide a cushion against unexpected losses.
- They also support expansion plans or finance future projects.
Contingency reserves
- These reserves are specifically set aside for unforeseen events or emergencies, such as:
- Economic downturns
- Litigation, or
- Natural disasters
Dividend equalisation reserves
- Companies establish these reserves to maintain a consistent dividend payout to shareholders, even during periods of fluctuating profits.
Statutory reserves
- Sometimes jurisdictions require companies to set aside a portion of their profits as statutory reserves.
- For example,
- As per Section 117(c)(1) of the Companies Act, 2013, a company must create a debenture redemption reserve for the redemption of debentures.
- Banking companies are required to maintain a reserve equivalent to 25% of net demand and time liabilities.
Capital reserves
- Capital reserves are created from profits generated through non-operational activities, such as:
- Sale of fixed assets or investments
- Profit generated from re-issue of forfeited shares
- Usually, these reserves are earmarked for specific purposes, such as:
- Debt repayment
- Capital expenditures, or
- Business expansion
Revaluation reserves
- Under specific circumstances, business organisations are required to revalue their assets.
- For example,
- As per the Indian Partnership Act, 1932, a partnership firm must revalue its assets upon admission, retirement, or death of a partner
- Any increase in the value of the assets is transferred to revaluation reserves.
How does analysing reserves in balance sheet help investors?
Most investors perform a fundamental analysis of the companies for profitable share trading. They do so by analysing different types of reserves in the balance sheet. Let us see what they usually infer:
1. Financial stability
Reserves, particularly general reserves or retained earnings, indicate a company's ability to weather economic downturns or unexpected challenges. A healthy reserve balance suggests:
- Financial stability and
- The ability to sustain operations without relying solely on external financing
2. Dividend sustainability
Several income-oriented investors assess the reserves of dividend-paying companies. This assessment helps in understanding the sustainability of dividend payouts. As per a general rule of thumb, companies with ample reserves can:
- Maintain consistent dividend payments
- Satisfy the dividend expectations of its shareholders
3. Ability to manage emergencies
An analysis of contingency reserves helps determine how proactively a company manages its business risks. A sufficient allocation to contingency reserves indicates that the company is prepared for unforeseen events, such as:
- Litigation
- Regulatory changes, or
- Economic recessions
4. Future growth potential
By analysing capital reserves and specific reserves, investors become aware of a company's:
- Growth strategy and
- Investment priorities
Usually, companies with significant reserves earmarked for expansion, research and development (R&D), or acquisitions have stronger growth prospects compared to those with limited reserves.
How to perform fundamental analysis through reserves in balance sheet?
A fundamental analysis through reserves in a balance sheet helps to understand a company’s:
- Financial condition
- Risk profile, and
- Growth potential
Let us understand how to do it through simple steps:
Step I: Obtain financial statements
- Refer to a company's financial statements, which are:
- Balance sheet
- Income statement, and
- Cash flow statement
- You can collect these documents by accessing the company's official website or regulatory filings.
Step II: Review the balance sheet
- Start by reviewing the balance sheet.
- Identify the various types of reserves and their balances.
Step III: Analyse trends
- Compare the trend of reserves over multiple periods, such as quarterly or annually.
- Look for trends in:
- Reserve growth or
- Reserve decline
- Assess the reasons behind these changes.
- Significant increases in reserves indicate improving profitability.
- Whereas decreases in reserves indicate concerns about:
- Earnings quality or
- Capital allocation decisions
Step IV: Compare reserves to earnings
- Evaluate the relationship between:
- Reserves and
- Company's earnings
- Calculate the reserve-to-profit ratio (reserves divided by net income).
- This will help you assess the proportion of profits retained by the company.
- A higher ratio suggests that the company has retained a greater portion of profits for future growth.
Step V: Consider industry norms
- It is one of the most important steps.
- After collecting all the information in the above steps, now is the time to compare the company's reserve levels to industry peers and benchmarks.
Let us understand this step using a hypothetical example. Say there are two companies in the retail sector. Have a look at their reserves in the balance sheet and also the industry average.
Particulars |
General reserve |
Contingency reserve |
Dividend equalisation reserve |
Company X |
Rs. 50 lakh |
Rs. 20 lakh |
Rs. 10 lakh |
Company Y |
Rs. 30 lakh |
Rs. 15 lakh |
Rs. 5 lakh |
Industry average |
Rs. 40 lakh |
Rs. 18 lakh |
Rs. 8 lakh |
The comparison
- Company X
- Its overall reserves are higher than the industry average
- This indicates a conservative approach to retaining profits for future use or investment
- Company Y
- Its reserves are more or less in line with industry norms
- This suggests a balanced approach to reserve management.
The interpretation
Company X (more favourable) |
Company Y (less favourable) |
|
|
Conclusion
Reserves in a balance sheet are profits set aside by business organisations for specific purposes. Usually, companies maintain several reserves such as general reserve, dividend equalisation reserve, capital reserve, and many more. Following the Indian Accounting Standards, these reserves are displayed on the liability side of the balance sheet. Investors often analyse them to identify financially stable and resilient investment opportunities.
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