After the end of the fiscal year, companies must decide how to allocate the profit earned during the year. This decision is made at the annual general meeting. Once the decision is made, it is up to the accounting staff to record the allocation of earnings. The most common uses for a company’s profits are reserves , profit distribution , and offsetting losses from prior fiscal years.
In this blog post, we will explore the different types of reserves established in the General AccountingPlan , with a special focus on equalization and capitalization reserves.
A company’s reserves are accumulated funds resulting from the retention of undistributed profits. They serve as a financial cushion to address contingencies and ensure economic stability.
Regular Accumulation: Determine a consistent percentage of profits to be retained annually.
Needs Assessment: Regularly review the adequacy of reserves based on projections and operational needs.
Financial Flexibility: Maintain a balance between dividends and retained earnings, adapting to economic changes.
Allocating a portion of profits to reserves is a matter of financial prudence. Rather than distributing all profits to shareholders, many companies choose to retain a portion and strengthen their financial structure. This strategy offers several advantages:
It ensures long-term solvency
Reserves increase equity, which improves the company’s financial position and its ability to take on debt or weather crises.
It allows for reinvestment in the business
With available equity, the company can undertake new investments without having to resort to external financing.
It complies with the law
Some reserves are required by law and must therefore be set aside before distributing profits.
It builds confidence
A company with well-funded reserves conveys financial strength to investors, financial institutions, and suppliers.
This reserve is required by law and stipulates that companies must set aside at least 10% of their profits until the reserve reaches 20% of the company’s capital stock. Its purpose is to provide a solid foundation for the company and to protect the interests of shareholders and related third parties.
These are established voluntarily by the company for the purpose of self-financing. They allow the company to accumulate internal resources for future investments, undertake market expansion initiatives, or address potential contingencies with greater financial autonomy.
This reserve is established voluntarily and allows companies to save on taxes. They may allocate up to 10% of their profits to this reserve without having to reinvest it in their own assets. As a result, companies can benefit from a reduced tax rate.
This reserve is also voluntary and is intended for companies that qualify for the special small-business tax regime. It allows the positive taxable income to be reduced by 10%, up to a maximum limit of one million euros. The smoothing reserve anticipates the use of negative tax bases that will be generated over the next five years, thereby reducing the company’s tax burden.
The decision on how to distribute profits rests with the general meeting of members or shareholders. This meeting is typically held once the financial results for the fiscal year have been approved and, among other matters, determines the allocation of net income: what portion is allocated to dividends and what portion to reserves.
This resolution must comply with current regulations, the articles of incorporation, and, in some cases, the compensation policy agreed upon with the shareholders. It must also take into account the company’s economic and financial situation.
For example, a company with accumulated losses or low solvency will likely choose to bolster its reserves rather than distribute dividends. In contrast, a company in a solid financial position may be able to provide greater returns to its members.
Managing profits and reserves is one of the most strategic decisions a company can make. Here’s why:
It influences future financing
The more reserves a company has, the greater its equity, which can make it easier to obtain bank financing or attract outside investment.
It affects dividend policy
Shareholders must understand that profits cannot always be distributed. Sometimes, it makes more sense to reinvest in the business.
It strengthens stability during adverse economic cycles
In times of uncertainty, having reserves can mean the difference between surviving or going out of business.
It enables long-term planning
A company that builds up reserves is better positioned to execute growth plans or seize new opportunities.
In short, the allocation of profits is no minor decision. Setting aside reserves is not only a legal requirement in some cases but also a responsible management practice. Companies that reinvest part of their profits are investing in their sustainability, growth, and adaptability.
Therefore, if you’re an entrepreneur or part of a company’s management team, it’s essential to consider the strategic value of reserves. Furthermore, understanding their types and uses will allow you to make more informed decisions that align with your organization’s long-term goals.