Free reserves are a term in the financial world that is used in relation to the accounting and equity capital of companies. They refer to that portion of equity capital that is not directly disclosed as legally required reserves and can be used for various purposes. These include, for example, investments, debt repayment, or strengthening liquidity. In this glossary entry, the term 'free reserves' is explained in more detail, and its significance for companies and investors is discussed.
Definition and Origin of Free Reserves
Free reserves represent a portion of a company’s equity capital that is not directly disclosed as legally required reserves. They are thus a part of the balance sheet equity that is not bound by specific usage restrictions. Free reserves can come from various sources, such as:
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- Profit reserves from non-distributed earnings Â
- Capital reserves from issuing shares above the par value Â
- Dissolution of hidden reserves
Function and Importance for Companies
Free reserves fulfill various functions for companies and are of high importance for financial stability and flexibility. Among the most important functions are:
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- Financing of investments: Companies can use free reserves as equity for investments in fixed assets or intangible assets. This enables companies to expand or modernize their business activities without relying on external capital. Â
- Strengthening liquidity: With the help of free reserves, a company can improve its liquidity and thus ensure its ability to pay suppliers, employees, and other business partners. This can be particularly important in economically difficult times. Â
- Debt repayment: Companies can use free reserves to settle existing debts or liabilities. This can improve the company's balance sheet structure and reduce its ratio of external capital.
Importance for Investors
For investors, free reserves are an important indicator of a company's financial stability and flexibility. They can serve as a measure of the company's ability to invest in new projects, pay off existing debts, or weather difficult periods. Companies with high free reserves are generally considered more solid and less risky than those with low free reserves.
Accounting and Disclosure in the Annual Balance Sheet
Free reserves are disclosed in a company's annual balance sheet as part of the equity. They are to be recorded separately from the statutory reserves, such as the legal profit reserve or capital reserve. Usually, free reserves are disclosed under the items "Profit Reserves" or "Other Reserves," depending on their origin. In the case of public companies, free reserves are found under the items "Profit Reserves" or "Capital Reserves."
Tax Treatment of Free Reserves
In Germany, free reserves are subject to corporate income tax when they originate from the company's profits. However, this is only the case when the free reserves are distributed to shareholders in some form, for example, as dividends. As long as the free reserves remain within the company and are not distributed, no taxes are incurred. Therefore, the formation and dissolution of free reserves can also represent a tax planning opportunity for companies.
Conclusion
Free reserves are a significant part of a company's equity capital and are highly relevant to its financial stability and flexibility. They can be used for various purposes, such as financing investments, debt repayment, or strengthening liquidity. Investors should consider free reserves when evaluating companies, as they provide an important indicator of a company's financial health.
