Calculating your residual income can never be difficult if you get the residual income formula correctly.
The basic formula is based on the net inflow and outflow of an individual or a company as might be the case.
However, the formula is tweaked a bit depending on the key purpose that this valuation metrics would be used for.
There are various applications of the residual income starting from assessing an individual’s capability to repay a loan to a manufacturing unit’s expansion potential.
Therefore, calculating it can be quite simple.
Below, I am explaining how to calculate your residual income based on an accounting point of view.
However, as I have already explained here, residual income has a different definition from our point of view.
It is the income that will not be stopped if you stop working.
So it is completely dependent on the nature of your job and whether it is able to generate a residual income or not.
It is very important for your future to spend your time on the jobs the will keep on making money even if you stop working.
You can’t be dependent on social security, RRSP and things like that.
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The Residual Income Formula
RI = A – (B x C)
RI, in this case, stands for Residual Income.
A is the total net income on an operational level.
B represents the minimum expected return.
C is no doubt the average assets, again on operation basis.
Therefore, it is quite clear that formula uses actual figures more than the notional or estimated profit level.
As a result, they always become a way more accurate assessment of the financial state.
This is an important valuation entity not just for large corporates.
But it is also for many small time businesses and even self-employed individuals.
This becomes a very handy approach to judge the overall valuation for many individuals who are not really working at the moment to generate income and residual income is important for them.
But the mere formula for residual income would not be useful at all if you do not understand it in the appropriate context and use the right type of variables to truly bring forth its relevance.
It becomes extremely important for you to grasp how it works in sync with the other various elements of the balance sheet.
For example, the component ‘A’ in residual income formula is the net operating income.
But you can’t just have a reference figure.
You need to take into consideration your entire monthly income or the revenue that has been generated and then go on subtract the various capital costs and loan liabilities that you might have.
Let’s say you released a music album and perhaps sold about 10,000 copies.
Then your net operating income will be the actual amount after you subtract the cost involved in creating it, editing it, marketing it and designing the cover.
Once all these expenses are accounted for, the resulting amount would be your net operational income.
If you create an e-book, you won’t have any costs because you can sell millions of copies without having to pay for any hardware and duplication fee.
Therefore, any money that you make through selling your ebook, will almost be your profit.
Digital products are better to generate residual income because once they are created, they can be sold unlimitedly.
The cost of capital is no doubt the kind of cost involved in mobilizing the said assets to start generating income.
When the return on this basic investment is able to cover the cost and also create a surplus, you are then able to calculate the residual income based on the percentage of relative return.
The other aspect of the equation is the operating assets.
This essentially involves the kind of money that needs to be ploughed back into maintaining and further the production level thus far.
As a result, the more successful a company is, the better residual income can be expected from them.
Such is the value of this metrics that many companies base their business ethics on the principle of generating larger residual income.
How Is Residual Income Not Always Passive Income?
Perhaps one of the greatest benefits of using the residual income formula to work is that it easily enables you to identify the difference between residual income and passive income.
This is one of the core formulas that are enabling lots of businesses today to focus more on generating substantial residual income as opposed to passive income.
Another major advantage is that you can use this formula conveniently to create addition income channels.
The trick is as long as the result of the residual income formula is positive, it means that the business is generating additional revenue despite the cost involved.
Therefore, it would make sense for you to continue and further the scopes of such a business.
The Formula for Personal Residual Income
You already know the core formula for calculating residual income.
But you must understand it needs some tweaking depending on the specific purpose that it is employed for.
So when you set out to calculate personal residual income
The fundamental factor is that it is often also referred to as discretionary income.
It would be pretty simple to calculate it.
All you have to do is subtract the various expenses like loans and mortgages and look at the net amount remaining.
Therefore the formula is relatively a more simplified version incorporating these two simple parameters.
Residual Income (RI) = Total salary – debt outgo
For example, if your monthly salary is $10,000 and you have one mortgage payment of $2000, $1000 loan EMI and other expenses worth $2000, your residual income would be $10,000 – $5000 = $5000
Now if someone’s loan worthiness needs to be assessed, it would be based on this RI figure of $5000.
A higher RI would always entail a greater possibility of getting a loan.
The Formula for Business Residual Income
Now when the same residual income formula is used for assessing corporate accounts, it takes into account the many facets of operational income that go hand in hand with a business establishment.
The net operational income would be the total revenue subtracted from the cost of capital used up to create the kind of revenue that it starts to generate.
So it is not just the profit level, but profit subtracted from the basic return that the business is set to generate.
Residual Income = Net Operating Income – (Min Required Return x cost of operating assets)
When the residual income turns positive from this calculation, it is a major plus as it denotes that the business is profitable after all the costs and is creating a surplus profit over and above the basic minimum rate.
There the residual income formula is not just an easy way to grasp the true profitability of business.
But it also enables you to get appropriate indicators in terms of the financial viability of a business.
Even in personal employment terms, this formula is also beneficent in creating multiple channels of employment.
An individual can use this formula for getting the right perspective about the kind of surplus income they need to generate, and this leads to a far effective fund allocation.
That was all about the accounting aspect of residual income and the formula that accounts use to calculate it.