Residual income

Residual income is income that one continues to receive after the completion of the income-producing work. 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. In corporate finance, residual income can be used as a measure of corporate performance, 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.

Residual income is not a GAAP concept. It is an internal financial assessment technique to help scale the relative success or failure of specific business activities. It adjusts income for a presumed cost of capital (or other threshold rate of return). Although there are many variations of the residual income calculations, the general approach is portrayed by the following formula:

Residual Income = Operating Income – (Operating Assets X Cost of Capital)

Residual Income (RI) = Net profits – Equity Charge

Equity Charge = Total Equity × Cost of Equity Capital

Types of Residual Income

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.

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 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).

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.

Advantages of the Residual Income Method

The residual income method can be used in both performance appraisals of a project, division, and business valuations. It considers the future cash flows in the present value term, which is the most liked approach in investment appraisals.

Its benefits closely resemble those arising from the dividend discount model or discounted cash flow models in present value terms. Some benefits of the Residual Income method in performance appraisals and business valuations include:

• It appraises the project net income in terms of present value, the residual income then equals the net worth of the shareholders.
• It focuses on the economic profits of the business rather than operating profits.
• The Residual Income method includes the book value of stocks in addition to the future stock price appreciation.
• Residual income utilizes readily available data from the business financial statements.
• It offers an adequate performance measure in terms of shareholders’ expectations, often profit generating businesses may not be generating enough economic profits for the shareholders.

Disadvantages of the Residual Income Method

• As with any theoretical performance appraisal method, the residual income method also offers some limitations:
• The Residual Income model also uses the cost of equity and cost of capital from The Income statement, both of which are assumption based measure.
• The use of book value for stock appraisals or asset valuation in project appraisal may offer invalid forecasts, as the book value of asset may not be accurate as market or intrinsic values.
• The residual income calculations begin with the book value of stocks or the net profits from the Income statement, these accounting entries can be manipulated by managers to show positive results.
• Residual income discards the long-term gains arising with cash flows in the later stages of the project.