What Is Residual Income?
Residual income is excess income generated more than the minimum rate of return. Residual income is a measurement of internal corporate performance, whereby a company's management team evaluates the income generated relative to the company's minimum required return. However, in personal finance, residual income is the level of income an individual has after the deduction of all personal debts and expenses paid.
- Personal residual income is not the result of a job or hourly wages—it requires an initial investment either of money or time with the primary objective of earning on-going revenue.
- Residual income is regularly referred to as "passive income" for individuals or businesses.
- Examples of residual income include real estate investing, stocks, bonds, investment accounts, and royalties.
- For equity valuations, equity charge is calculated as the equity capital multiplied by the cost of equity.
- Corporate residual income is leftover profit after paying all costs of capital.
How Residual Income Works
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.
Although residual income is sometimes known as passive income, side hustles can be used to boost personal residual income.
Types of Residual Income
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.
Managerial accounting defines residual income in a corporate setting 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 is typically 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 - (minimum required return x operating assets).
In personal finance, residual income is known as disposable income. The residual income calculation occurs monthly after paying all monthly debts. As a result, residual income often becomes an essential 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.