What is Residual Income
Residual income is the amount of net income generated in excess of the minimum rate of return. Residual income concepts have been used in a number of contexts, including as a measurement of internal corporate performance whereby a company's management team evaluates the return generated relative to the company's minimum required return. Alternatively, in personal finance, residual income is the level of income that an individual has after the deduction of all personal debts and expenses have been paid.
BREAKING DOWN Residual Income
Residual Income measures net income after taking into account all required costs of capital related to generating that income. Other terms for residual income include economic value added, economic profit and abnormal earnings.
Residual Income for Equity Valuation
In equity valuation, residual income represents an economic earnings stream and valuation method for estimating the intrinsic value of a company's common stock. The residual income valuation model values a company as the sum of book value and the present value of expected future residual income. Residual income attempts to measure economic profit, which is the profit remaining after the deduction of opportunity costs for all sources of capital.
Residual income is calculated as net income less a charge for the cost of capital. The charge is known as the equity charge and is calculated as the value of equity capital multiplied by the cost of equity or the required rate of return on equity. Given the opportunity cost of equity, a company can have positive net income but negative residual income.
Residual Income for Corporate Finance
Managerial accounting defines residual income in a corporate setting as the amount of leftover operating profit after all costs of capital used to generate the revenues have been paid. It is also considered the company's net operating income or the amount of profit that exceed its required rate of return. Residual income is normally used to assess the performance of a capital investment, team, department or business unit.
The calculation of residual income is as follows: Residual income = operating income - (cost of capital x operating assets).
Residual Income for Personal Finance
In personal finance, residual income is also known as disposable income. The residual income calculation occurs on a monthly basis after all monthly debts are paid. As a result, residual income often becomes an important component of securing a loan.
A lending institution assesses the amount of residual income remaining after paying other debts each month. The greater the amount of residual income, the more likely the lender is to approve the loan. Adequate levels of residual income establish that the borrower can sufficiently cover the monthly loan payment.