Residual Income: What It Is, Types, and How to Make It

What Is Residual Income?

Residual income is the money that continues to flow after an initial investment of time and resources has been completed. Examples of residual income include artist royalties, rental income, interest income, and dividend payments.

The term residual income is used in other contexts:

• In personal finance, residual income can refer to an individual's discretionary income, or the total amount of money left over after paying all personal debts and obligations.
• In corporate finance, residual income is a measurement of corporate performance that reflects the total income generated after paying all relevant costs of capital.

How Residual Income Works 

Residual income broadly speaking is a measurement of tangential profits earned after subtracting all costs of capital related to generating that income. Other terms for residual income include economic value-added, economic profit, and abnormal earnings.

Types of Residual Income 

Stock Valuation

Residual income is also a valuation method for estimating the intrinsic value of a company's common stock. It accounts for the cost of capital, meaning the combination of debt and equity expended to finance the company's operations.

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 in this case 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. This 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.

The formula is:

Residual Income = Net Income - Equity Charge

Given the opportunity cost of equity, a company can have positive net income but negative residual income.

Corporate Finance

Managerial accounting defines residual income for a company as the amount of leftover operating profit after paying all costs of capital used to generate the revenues. It is also considered the company's net operating income or the amount of profit that exceeds its required rate of return.

Residual income in this case may be used to assess the performance of a capital investment, a team, a department, or a business unit.

The calculation of residual income is as follows: Residual income = operating income - (minimum required return x operating assets).

Personal Finance

In personal finance, residual income is synonymous with monthly disposable income. It is the total income that remains after paying all monthly debts.

Thus, residual income is often a key factor when a lender considers a loan application. An adequate amount of residual income indicates that the borrower can cover the monthly loan payment.

How to Generate Residual Income

Most sources of residual income require an upfront investment of money, sweat equity, or both. Some examples:

• Buy bonds. Once the bonds are purchased, the owner has a stream of cash available until the bonds reach their maturity.
• Buy a rental property. Renting out a second home or investment property is a sound way to add to your income without much effort after the initial investment. If you lack the seed money, consider renting out a spare bedroom.
• Invest in index funds: Your profits can grow over time even if you don't actively manage your investment.
• Peer-to-peer lending: The internet has opened the way to various types of residual income, including peer-to-peer lending. A number of platforms are available to facilitate personal unsecured loans between individuals at competitive rates of interest.
• Sell your stuff: In the broadest sense, residual income can be any side gig that adds to your income outside your regular job. eBay is good for cleaning out your closet and making money at the same time. Etsy is great for creative types who want to monetize a hobby.

Residual Income vs. Passive Income

The differences are subtle. Residual income may be passive income but passive income isn't necessarily residual.

In personal finance, passive income may be derived from stock dividends or from renting a room on Airbnb. There was an initial outlay of money to buy the stocks or the house, but a tangential benefit that costs little in additional time or effort has been derived from the initial investment. It is residual income as well as passive income.

• Passive income is earned with little or no effort required after the initial investment.
• Residual income, for an individual, means the free cash available for spending after all obligations are met.

The Bottom Line

Residual income is not free money. It requires an upfront investment of money, hard work, or sweat equity. But once that work is completed, a stream of income has been established that takes little or no effort to maintain.