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 = Controllable Margin – Average of Operating Assets * Required Rate of Return
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 = 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.
Residual Income in Personal Finance
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.
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