Search
  • Legis Scriptor

Residual Income and Procedure of its Assessment


Authored by - Sania Vinayan

Keywords - Residual Income, procedure, assessment


Abstract


This article aims to explain the meaning of ‘Residual Income’ and its procedural aspects of assessment. It shall also explore the different types of incomes and will highlight the significance of these concepts in the field of finance.

Introduction


Residual income is considered as one of the best types of income.[1]Essentially, residual is the opposite of a regular kind of income. Incomes usually have to be actively worked for. For example, income from a job needs consistent efforts. They are called active incomes. But residual income is in contrast with the purpose of active incomes. Residual income does not require continuous efforts. For example, giving off a house on rent. The income received (the rent) would come under residual income. These kinds of personal investments are those that can be acquired with almost negligible efforts. However, these are personal residual incomes.


In the corporate scene, residual income models are well sought out. It has been widely recognized as a beneficial tool for investment and research. The reason for its popularity nowadays is due to the shortcoming of traditional accounting. Specifically, although a company’s income statement includes a charge for the cost of debt capital, in the form of interest expense, it does not include a charge for the cost of equity capital. A company can have positive net income but still may not be adding value for shareholders if it does not earn more than its cost of equity capital. Residual income models explicitly recognize the costs of all the capital used in generating income. Although, this model is not newfound. The usage of this concept dates as far back as the 1920s when General Motors used the concept in evaluating business segments[2]


What is the meaning of Residual Income?


Residual Income is the income that a person keeps receiving even after retirement that is essential to be put for producing income. Some examples of this kind of income would include royalties, rental/ real estate income. Interest and dividend income, income from the constant sale of books, paintings, music, digital art, etc (consumer goods).[3]


Residual Income is also sometimes known as passive income. The reason being that active work or effort is not required for the ongoing flow of income. Residual Income can be viewed as the “leftover” income. It measures the net-income after taking into consideration all the costs of capital related to earning that income. It includes economic value-added, economic profit, and abnormal earnings.[4]


There are different types of Residual Income. Some of them are as follows:

  1. Equity Valuation

  2. Corporate Finance

  3. Personal Finance

Equity Valuation

What is the meaning of Equity?

In this context, equity refers to the shares issued by a company. The stakeholders of these shares are called equity shareholders. Under equity valuation, residual income represents the surplus-value to shareholders after the equity costs, their debts and liabilities have been compensated. Residual income is calculated as net income minus the 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. [5]

The calculation of Residual Income is as follows:

RI = Net Income – Equity Charge [6]

Corporate Finance

What is the meaning of Corporate Finance?

Corporate finance is the department of finance that deals with how corporations manage funding sources, capital structuring, and investment decisions. Corporate finance is primarily concerned with boosting shareholder value through long and short-term financial planning and the execution of various strategies. Corporate finance activities vary from capital investment decisions to investment banking.[7]

Residual Income in Corporate Finance:

In a corporate setting, residual income is defined as the amount of remaining operating profit after paying all costs of capital used to generate the revenues. It is also considered the company's net operating income. Residual income is typically used to assess the performance of the capital investment, team, department, or business unit. [8] Estimating the residual income allows companies to distribute resources amongst investments in a more efficient manner. When there is a positive RI, it means the company surpassed its minimal rate of return. On the contrary, a negative RI means it failed to meet the expected rate of return.[9]

The calculation of residual income is as follows:

Residual income = Operating income - (minimum required return x operating assets)[10]

Personal Finance


What is the meaning of personal finance?

Personal Finance deals with the income of the individual. Personal finance is a term that covers managing your money as well as saving and investing. It includes budgeting, banking, insurance, mortgages, investments, retirement planning, and tax and estate planning. It often refers to the entire industry that offers financial services to individuals and households and advises them about financial and investment opportunities.[11]

Residual Income in Personal Finance

Residual income is the level of income an individual has left after all personal debts and expenses are paid in personal finance. The level of income can be used to help figure out the creditworthiness of a potential borrower.[12]


The residual income of an individual is an important factor that banks and financial institutions undertake in determining whether the individual can avail loans. The higher the residual income of an individual, the higher are the chances of receiving a bank loan approval.

Conclusion


In conclusion, there are many types of residual income depending on the area of finance that is being dealt with. It includes personal, corporate, and equity valuation. Its standard method of assessing residual income varies, depending on its kind.

[1]https://money.howstuffworks.com/personal-finance/personal-income-taxes/how-is-residual-income-taxed.htm.

[2]https://www.cfainstitute.org/en/membership/professional-development/refresher-readings/2020/residual-income-valuation.

[3]https://www.investopedia.com/terms/r/residualincome.asp#:~:text=Residual%20income%20is%20typically%20used,required%20return%20x%20operating%20assets).

[4] S3

[5] https://corporatefinanceinstitute.com/resources/knowledge/valuation/residual-income/

[6] S5

[7] https://www.investopedia.com/terms/c/corporatefinance.asp

[8] S3

[9] S5

[10] S3

[11] https://www.investopedia.com/terms/p/personalfinance.asp

[12] https://www.investopedia.com/ask/answers/040615/what-difference-between-residual-income-and-passive-income.asp

References

1. Investopedia website referred: https://www.investopedia.com/terms/r/residualincome.asp#:~:text=Residual%20income%20is%20typically%20used,required%20return%20x%20operating%20assets).

2.https://www.investopedia.com/ask/answers/040615/what-difference-between-residual-income-and-passive-income.asp

3. https://www.investopedia.com/terms/c/corporatefinance.asp

4. https://www.investopedia.com/terms/p/personalfinance.asp

5. Corporate Finance Institute website:

http://dge/valuation/https://corporatefinanceinstitute.com/resources/knowleresidual-income/

6. CFA institute website:

https://www.cfainstitute.org/en/membership/professional-development/refresher-readings/2020/residual-income-valuation

7.https://money.howstuffworks.com/personal-finance/personal-income-taxes/how-is-residual-income-taxed.htm