Residual Income
It is the net income earned beyond the minimum rate of return assigned to the investment
What Is Residual Income?
Residual income is the net income earned beyond the minimum rate of return assigned to the investment. It offers a look into an individual's financial stability.
It is usually calculated monthly and reflects the income a company or individual has left over at the end of the month after all required payments are made (such as bills, mortgage payments, and other large long-term debts).
Let's take the example of Khalif, who goes to the bank to apply for a loan. The bank asks him to provide a record of how he pays his regular monthly bills and a credit card, car, mortgage payments, etc.
If his income barely covers his essential bills and other payments, then he is unlikely to get approved by the bank. However, if he can show that he can pay his bills and still have savings at the end of the month, he is more likely to secure a loan.
This saving at the end of the month after meeting all expenses is known as residual income.
Residual Income Formula
The formula is:
Residual Income (RI) in Corporate Finance = Net Operating Income - (Minimum Required Return * Total Operating Assets)
Let's delve into another example in the article to understand this better. Anas, who owns a greengrocer, wants to know how much RI he's making from his Fruit and Vegetable (F&V) shop.
He spent $250,000 to buy a digital scale and other equipment. He also has a net operating revenue of $50,000 for the year. He currently earns a return of 10%, so he aims for a minimum required return of 10%.
Let's analyze and dissect the meaning of this problem and see the result of Anas greengrocer Fruit and Vegetable shop.
We see Anas's net operating income as $50,000 and his operating cost as $250,000 with the minimum required return of 10%, so when calculating 50,000 minus 0.10 (10%) multiplied by 250,000, his greengrocer would have a result of $25,000.
Residual Income (RI) = Net Operating Income - (Minimum Required Return * Total Operating Assets)
= 50,000 - (0.10 * 250,000) = 25,000
This means Anas has a remaining net income of $25,000 after the capital cost has been deducted and also explains that his (F&V) shop is earning more than the minimum 10% required.
Anas effectively manages his income and expenses leaving additional income at the end of every month. Therefore, he can use his excess earnings to fund an expansion, pay debts, or distribute dividends to investors.
Types of Residual Income
In this article, we shall delve into three types of residual income.
RI in Equity Valuation
In equity valuation, RI is the money that a company regularly generates for estimating the intrinsic value of the company's share/stock.
In such a way, the company is valued on the sum of its book value and the present value of the expected future RI. It measures the economic profit, which is the profit remaining after deducting the opportunity cost for all sources of capital.
The formula for calculating it in equity valuation is as follows:
Residual Income (RI) = Net Income - Equity Charge
It is the net profit that's been calculated as the value of the company's equity capital multiplied by the cost of equity. Also, the company can have a positive income with a negative RI, given the opportunity cost.
RI in Corporate Finance
In corporate finance, it is calculated as the operating profit amount after paying all capital costs used to generate the revenues. It is also considered the company's net operating income or the amount of profit exceeding its required return rate.
It is usually utilized to assess the performance of the business unit, department, team, or even capital investment.
When it is a positive value, it means the company exceeds its minimum rate of return. On the other hand, when it is a negative value, it has failed to meet the minimum rate of return.
Residual Income (RI) = Operating Income - (Minimum Required Return * Operating Assets)
RI in Personal Finance
In personal finance, it refers to an individual receiving excess income after paying all monthly debts such as mortgages and car loans.
It often becomes related to securing a loan as the lending firm assesses the RI remaining after paying each month's debts, and the approval of the loan should be more significant.
The RI is the process of planning and managing personal financial activities. It is known as disposable income or discretionary income.
It is a prominent factor as it is one of the statistics used by banks before an individual’s loan gets approved.
Banks use this value to determine whether an individual has enough income from daily wages for an additional loan. If an individual shows a high RI, his loan is more likely to be approved than an individual with a low RI.
Residual Income vs. Passive Income
Although both these terms look similar, in business and individual, they contain two different meanings. So let us dive into it!
The key feature that changes both is that, by definition, it's an income that is not generated directly by a company.
From this article, we understood the meaning of RI, which measures an individual's money left over after deducting expenses made from their overall income.
Whereas passive income (PI) represents the money earned by an individual with little to no effort to obtain it. PI can be made even while the person is asleep. The income stream is taxed differently in both cases - active and passive.
Let's take a look at an example. The total Gross income for Elijah is $31,000. He has a house mortgage to pay, which comes to about $20,000 annually. His car mortgage comes to about $5,000 per annum, and living expenses come to about $4,000 (food, entertainment, and utilities) annually.
After deducting these items, Elijah still has $2,000 in his pocket as his leftover income (31,000 - 20,000 - 5,000 - 4,000). This is Elijah's residual income. He can choose to do whatever he wants with it.
In contrast, Rohini, a blogger, decides to earn passive income. For this purpose, she inserts an affiliate link in most of her posts. She generates passive income when visitors to her blog click on those links.
How to Generate Residual Income
There are many different options for obtaining or increasing it. These options can be practiced one by one, or they can be mixed. Below are the different ways of building and expanding your RI
Real Estate
Any amount of cash flow leftover is your RI. Investing in real estate is a type of earned income that, after initial dealings and hassles, often seems to require little effort, similar to passive income.
Take note that purchasing a house to live in is a slightly different situation. When buying a house to live in, if its value appreciates, its net value has a chance of increasing.
Suppose you own a house and rent it out to people. As a landlord, know what other people's desires are: in exchange for owning, repairing, and maintaining the property, you get a monthly check from your tenants that offsets the mortgage.
A monthly rent check can lead to a sizable income each year if you do not have a mortgage and own the house outright.
Entering into real estate also comes with serious risks. Most times, real estate investing requires more extensive upfront capital requirements and is prone to a semi-volatile market in addition to the high insurance costs.
Dividend Income
There are two main ways an individual can earn RI through the stock market: first, by the appreciation in the value of the assets you invest in, and second, through dividend income.
Some investors can build healthy funds to live off the fund's dividend payments. But, most of the time, companies with well-established business operations that generate significant and steady cash flow are more likely to distribute dividends.
Working with Affiliate Marketers and Other Online Earnings Options
You might have heard your favorite Youtuber constantly barking at you to like, share, and subscribe to their channel. This is because subscriptions, likes, and engagement are the main drivers of income for online earning and video creation.
They might see a portion of profits driven by ads before, after, or during their content. Content creators can also mention a specific product within the video to make money through an affiliate relationship or brand deal.
There are different platforms that creators can such as Metaverse, digital marketing, Instagram, Facebook, etc., for their own private/public blogs.
Creators can also set up an affiliate account with a vendor of the product they are recommending and generate income which requires some effort in content creation.
Freelancing
If you are a photographer, pamphlet writer, or even have other marketing skills, you can take them to the street and sell them as your service. It's a way to increase the overall income you bring and RI you have.
Writing in a Book
You can share your knowledge by drafting your book. Most drafting contracts include royalties, meaning you earn per book sold. Once it's written and drawn, it generates income in the coming years.
Online Courses
If you're a teacher or a mentor and love explaining concepts to others, you can create your channel on Youtube or other learning platforms and explain it to others. Your knowledge and ability to help others learn can bring you some extra cash.
Recurring Online Sales
If you can create or make items, such as photographs, art pieces, or even small souvenirs, these online marketplaces are also a great option to generate additional RI. You can even ship them to various locations to buy your product.
Stock Picking
Participation in the stock market can be active as you are to pick out every stock or semi-passive with the usage of a robot advisor account that will pick stocks, analyze, and do the work for you.
In this case, there are two extremes, a brokerage account and building your portfolio of index funds.
Royalties
The income an individual receives after they do all the work necessary in advance for the product to be on display is the amount an individual receives in royalties.
A royalty is paid to the owner of their product by those using that product on an ongoing basis. It can be any of these items, such as assets, intellectual property, or copyright material, where a person can build royalties.
Researched and authored by Savan Sabu | LinkedIn
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