Residual Income Formula – How to Calculate Residual Income

Residual Income Formula

Residual Income Formula = Controllable Margin – Average of Operating Assets x Required Rate of Return

• Controllable margin – is also known as segment margin.  It refers to the project’s revenue minus expenses. The required rate of return is the minimum amount of return that a company is willing to accept from a given investment.
• Average operating assets – are the kind of resources required to sustain the company’s operations. They include items like cash, accounts receivable, inventory, and fixed assets.

What Is Residual Income?

Residual income is income that one continues to receive after the completion of the income-producing work.  The residual income formula measures net income after taking into account all required costs of capital related to generating that income.  Examples of residual income include royalties, rental/real estate income, interest and dividend income, and income from the ongoing sale of consumer goods (such as music, digital art, or books), among others.  Residual income in corporate finance can be used as a measure of corporate performance.  It is a means whereby a company’s management team evaluates the income generated after paying all relevant costs of capital. Alternatively, in personal finance, residual income can be defined as either the income received after substantially all of the work has been completed or as the income left over after paying all personal debts and obligations.

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.  However, there are differences between the terms. Examples of residual income include real estate investing, stocks, bonds, investment accounts, and royalties. For equity valuations, the 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. Residual income is sometimes known as passive income.  Side hustles can be used to generate income and boost personal residual income.  (Source: investopedia.com)

Types of 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.

Equity Valuation

For equity valuations, 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.

Corporate Finance

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 capital investment, team, department, or business unit.

Personal Finance

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.  (Source: investopedia.com)

Residual Income Formula for Personal Finance – Example

For example, assume that worker A earns a salary of \$4,000 but faces monthly mortgage payments and car loans of \$900 and \$700, respectively. His discretionary income is \$2,400 (\$4,000 – (\$900 + \$700)). Essentially, it is the amount of money that is left over after making the necessary payments.

Analyzing Residual Income

The calculation of residual income results in a dollar value. A positive amount indicates that the subunit or investment was able to generate more than its minimum or desired income. The higher the residual income, the better. Return on investment (ROI) and residual income (RI) can both be used to evaluate investments.   However, some investments that failed in the ROI test because of low rates may pass the RI test if they have positive amounts. The major disadvantage of residual income is that it cannot be used in evaluating investments of different sizes. The results would favor bigger investments because of the larger dollar amounts involved.

There are varied uses of residual income as a financial metric. In terms of personal finance, residual income, also known as discretionary income. It refers to earnings or salary that remains after an individual has paid his mortgage, car loan, and other monthly expenses. Residual income is an important part of personal finance. Banks usually rely on this value to determine if someone can afford a loan. It’s common knowledge that banks check whether or not a loan applicant is earning enough income to cover his current costs, plus a new loan. A high residual income will help a loan application get approved. Likewise, a low residual income will likely lead to rejection.

Residual Income vs Passive Income

The investment community may define residual income as revenue that comes from a passive source. Simply put, that is a source that keeps the earnings coming without any time or effort directly devoted to it. The investment, by itself, opens up additional channels where income can stream through. Common examples of passive income are royalties, interest, and rent. A dividend stock, for instance, will continue generating dividends after a one-time cash investment. There is no need to spend time or resources to make it earn those dividends. It just does by design.

Passive income and residual income, however, are two entirely different concepts. Passive income is cash flow made from a passive source. On the other hand, residual income is not actually an income. Instead, it is merely a calculation of how much earnings will be left after all costs have been paid or the minimum rate of return has been met. Business residual income, on the other hand, is defined as the amount of unused operating revenues after the capital cost required to earn the revenues has been paid. It is thus synonymous with net operating income, or the money that comes in excess of the minimum required return.

(Sources: accountingverse.com & studyfinance.com)

Residual Income vs ROI

Return on investment (ROI) is another performance evaluation tool.  ROI equals the operating income earned by a department divided by its asset base. Even though ROI is the most popular measure, it suffers from a serious drawback. It creates an incentive for managers to not invest in projects which reduce their composite ROI even though those projects generate a return greater than the minimum required return.

For example, consider a department with a current operating income of \$200,000 and an asset base of \$1,000,000. The minimum required return is 15%.  The department manager is considering a project that will earn \$50,000 but will require additional capital of \$300,000. The department manager could decide not to accept the project.  This is because his current ROI is 20% (=\$200,000/\$1,000,000).  By accepting the project, it will reduce his ROI to 19.23% (=(\$200,000 + \$50,000)/(\$1,000,000 + \$300,000)). However, from the company’s perspective, accepting the project is the right thing to do.  This is because the project’s return of 16.67% is higher than the minimum required return.

If department managers are evaluated based on the residual income that their departments generate, they have an incentive to accept all such projects which earn a return greater than the minimum required rate of return. This is one of the advantages that the residual income approach has over the ROI approach.

The Disadvantage of Using Residual Income

But residual income itself suffers from a bias, it does not allow for the ranking of departments based on the dollars they earn per \$100 of investment. Since capital is a scarce resource, a company may not be able to arrange money for all projects with positive residual income. It is quite possible that some departments may be able to accept a lower ROI project while a higher ROI project at another department may not get the required investment.

(Source: xplained.com)

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