Learn about the different meanings of residual income
What is Residual Income?
Residual income (RI) can mean different things depending on the context. When looking at corporate finance, residual income is any excess that an investment earns relative to the opportunity cost of capital that was used.
However, in the context of equity valuation, residual income refers to the net income after accounting for all the stockholders’ opportunity cost in generating that income.
Residual Income in Corporate Finance
Calculating the residual income enables companies to allocate resources among investments in a more efficient manner. When there’s a positive RI, it means the company exceeded its minimal rate of return. On the contrary, a negative RI means it failed to meet the projected rate of return.
RI Formula
RI = Controllable Margin – Average of Operating Assets * Required Rate of Return
Where:
- Controllable margin, which is also known as segment margin, refers to the project’s revenue less expenses. 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, among others.
Residual Income in Equity Valuation
When it comes to equity, residual income is used to approximate the intrinsic value of a company’s shares.
In such a case, the company is assessed based on the sum of its book value, as well as the present value of anticipated residual incomes. The RI helps company owners measure economic profit, which is the net profit after subtracting opportunity costs incurred in all sources of capital.
RI Formula
RI = Net Income – Equity Charge
Simply put, the residual income is the net profit that’s been altered depending on the cost of equity. The equity charge is computed by multiplying the cost of equity and the company’s equity capital.
In the context of personal finance, residual income is another term for discretionary income. It refers to any excess income that an individual holds after paying all outstanding debts, such as mortgages and car loans.
For example, assume that worker A earns a salary of $4,000 but faces monthly mortgage payments and car loans that add up to $800 and $700, respectively. His RI is $2,500 ($4,000 – ($800 + $700)). Essentially, it is the amount of money that is left over after making the necessary payments.
Residual income is an important metric because it is one of the figures that banks and lenders look at before approving loans. It helps the institutions determine whether an individual is making enough money to cater for his expenses and secure an additional loan. If one demonstrates a high RI, his loan is more likely to be approved than for an individual with a low RI.
Additional Resources
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FAQs
The calculation of residual income is as follows: Residual income = operating income - (minimum required return x operating assets).
What is considered residual income? ›
It's the amount you have left over after you cover necessary bills, such as your mortgage or car payment. Personal residual income lets you know how much money you have to cover your lifestyle expenses, save for emergencies or upcoming events, or invest for your future.
What does 120% residual income mean? ›
If your DTI is too high, your lender may still give you a loan if you have 120% residual income. Residual income is the remainder of your gross income after subtracting all of your personal debts and expenses.
What are the minimum requirements of residual income? ›
VA Residual Income Chart: What Are The VA Residual Income Requirements?
| Family Size | Northeast | Midwest |
|---|
| 1 | $450 | $441 |
| 2 | $755 | $738 |
| 3 | $909 | $889 |
| 4 | $1,025 | $1,003 |
1 more rowDec 8, 2023
Definition. The residual for each observation is the difference between predicted values of y (dependent variable) and observed values of y . Residual=actual y value−predicted y value,ri=yi−^yi.
How to calculate residual income for self-employed? ›
To find your residual income, subtract all of your debt, other financial obligations, and living expenses from your gross income (the amount of money you make before taxes).
How to calculate residual income calculator? ›
There is a number of ways to calculate residual income, but the most recognized formula is: RI = Net Operating Income − (Minimum Required Return × Cost of Operating Assets) For example, if your net operating income is $3000, the minimum required return is 10%, and the cost of operating assets is $1000, then your RI ...
How much is the residual income? ›
To calculate it, add your bills and long-term debts for each month. Then subtract those expenses from your take-home pay. Whatever's left over is your residual income.
What is positive residual income? ›
Residual Income in Corporate Finance
When there's a positive RI, it means the company exceeded its minimal rate of return. On the contrary, a negative RI means it failed to meet the projected rate of return.
Is it better to have a higher residual income? ›
Personal finance
A person with high residual income can afford to take on additional debt, so banks routinely use residual income calculations to help make loan approval decisions.
Residual income can be increased through various methods such as real estate investment, passive income streams, and stock market investing. Other options include affiliate marketing, freelancing, and selling items on online marketplaces.
What should residual income be? ›
Residual income is your monthly income minus your monthly debts, like mortgage payments and credit card bills. Residual income can boost your finances and help you pay off debt faster, set aside money for retirement and build up your savings.
How do you calculate the residual income? ›
Residual income is calculated as net income minus a deduction for the cost of equity capital. The deduction, called the equity charge, is equal to equity capital multiplied by the required rate of return on equity (the cost of equity capital in percent).
What are the limitations of residual income? ›
Although residual income has various advantages, it also comes with several challenges and drawbacks, such as the need for effective cost allocation, potential for promoting risk aversion, short-term focus, and difficulty in comparing performance across different companies or industries.
How is residual value calculated? ›
Residual Value = Salvage Value - Cost of Asset Disposal
The difficulty in calculating residual value lies in the fact that both the salvage value and the cost to dispose of the asset may not truly be known until disposition.
What is the formula for residual return? ›
The residual return is the return relative to beta times the benchmark return. To be exact, an asset's residual return equals its excess return minus beta times the benchmark excess return.
How do you calculate residual balance? ›
Calculating residual value requires two figures namely, estimated salvage value and cost of asset disposal. Residual value equals the estimated salvage value minus the cost of disposing of the asset.
What is the formula for residual profit in accounting? ›
It represents net income minus the fair rate of return multiplied by average operating assets. \n Consider this formula for calculating residual income: R I = N I − ( C E × A O A ) where: RI = Residual Income. NI = Net Income.
