Residual income is the income that keeps coming even if you stop working. I know this definition is different from the general accounting definition that residual income has. But this is our definition on this site because we offer some business systems that generate residual income. The term residual income is usually used to denote the exact amount of money that an individual has after taking care of all personal debt and expenses. This is the amount of money that you are left with after paying all your loans including mortgages and other similar liabilities. Usually, this is calculated on a monthly basis after payment of all debts.
The concept of residual income isn’t however only used to denote income and expenses on a personal level. Even when you are considering income and expenses of a large corporate, there are several instances where management teams use this basic parameter to calculate the returns generated by the company over the minimum required rate. In many ways, it is an estimation of the exact cash remaining with the company after meeting all expenses in terms of cost of capital and the like. As a result, this is a very popular approach used both in corporate finance as well as personal finance to estimate the financial viability of any deal or arrangement correctly. However, residual income has a more beautiful meaning for the Internet entrepreneurs like bloggers, Internet marketers and DT system developers.
It is the income that keeps coming even if you stop working. This is the real meaning of residual income. I will talk about this definition more after talking about the financing and accounting definition. So before we get any further, it is critical to properly grasp the general residual income definition and understand in what context you can use this fundamental financing technique for long-term gains.
What Is Residual Income?
Residual income is a unique approach to equity valuation that even accounts for the cost of equity capital. The residual, in this case, highlights the excess that is left after meeting all outgoing requirements. Therefore, in the case of corporate or larger financial arrangements, residual income, could also mean additional opportunity or rather the opportunity cost relative to the book value of the equity. So once the actual cost of capital is accounted for, the amount of income generated beyond is residual income.
So if you are trying to gauge the extent of this income on your existing investment, it will no doubt be the net income that you can earn over and above the minimum guaranteed rate of return as you would have in a time-based deposit scheme with a set rate of interest. This income format would also include any type of royalty that you might earn from the intellectual property that you might own like music royalty or royalty from patents/books. This obviously is residual income pretty much the same way as the ones that you can earn from your investment. These almost always are over and above the basic minimum income that is accounted for and can be termed as extra that helps you access some extra opportunity as well.
So if you set out to define residual income, it is essentially an accounting terminology that is used to measure and assess the relative growth and success of an individual or business. It can help you provide a comprehensive insight into the actual rate of return in case of invested wealth and the average financial viability of any financial deal. For example, if you were to handle the corporate finances of two companies in a similar business with a similar type of profitability, would your approach be same for both?
Well, not really!
The business that requires a high amount of resources to generate the same amount of profitability will no doubt have a lower RI or residual income, and that can’t be good news for the business.
Formula to Calculate Residual Income
When you try to define residual income, in many ways, it is incomplete without understanding the formula for calculating the same. You can assess the residual income by multiplying the cost of capital to operating assets and then subtract that value from the operating income. The value thus arrived is your residual income and often provides you with clear indicators on the actual rate of return. In accounting parlance, this is the most common measure used for assessing the overall performance of any business or an individual. It highlights the returns earned thus far to the minimum return guaranteed and is denoted by the formula:
Residual Income (RI) = Net Operating Income – (Min required return x Avg Operating assets)
The net operating income is undoubtedly the actual revenue minus the expenses, and the minimum return is, in effect, the actual opportunity cost of running the entire operation. So, in other words, it could also mean the average percentage return that a business can expect to earn on specific projects. The asset base of the business is denoted by the average operating assets. Therefore, the biggest use of this metric is that the residual income clearly highlights the excess return that has been earned by a department in actual terms. When the residual income comes positive, it means that the business has additional cash flow above the required minimum return and a negative one is a big red flag for the business. It means that the business is unable to even churn out the basic minimum return on the base investment.
1. Concept & Comparison of Residual Income
The very concept of the term ‘residual income’ arises from the underlying idea that every investor needs to earn a basic rate of return from the resources in which they invest. This rate of return is seen as means of compensating them for the opportunity cost of generating the resource and bearing responsibility for the associated risk element. This is exactly why it is based on the overall cost of equity and has to be subtracted from the overall net income generated. The return that is generated is also instrumental in helping create shareholder value and amplifying the ultimate worth of the business/service that is being considered.
You have to understand that mere declaration of profit does not make a business profitable, economically it could still be an unprofitable enterprise, and only a metrics like residual income can project the right picture. Therefore, you can understand that the residual income is an important aspect for judging the valuation of a business and can often be substituted for other valuation models like the DCF. The residual income based valuation model is most appropriate when the business has a rather uncertain dividend paying pattern or might not really be paying dividends at all.
In a negative free cash flow situation with hopes of generating positive cash flow or for easy recognition of the overall intrinsic value of a firm, this can be a rather handy technique. The concept of residual income is one of the cardinal accounting approaches for identifying the right and relevant value of the business or a specific department that might be under consideration. In this context, there is another factor that is often considered, and that is EVA. While some might argue that this is quite similar to residual income, but a closer study would reveal that there are some technical differences between EVA and RI.
2. History of Residual Income
One fact that goes hand in hand with the query, ‘what is residual income’ is when it was introduced in accounting practices. A close study of world accounts would reveal that it’s most pronounced use was noticed for the first in the General Electric income statement in the 1950s. However, the concept and its origin go much deeper. The most primitive and almost the first demonstration of this principle was first noticed in Alfred Marshall’s Principles of Economics in 1890. However, according to some other experts, the earliest mention of this concept was found in 1777 in a book titled An Introduction to Merchandize by Robert Hamilton.
Historical evidence highlights that by the 1970s, the theoretical foundation of residual income was well in place and was increasingly being seen as an important component for calculating value based management concepts. However only by the 1990s, when there were some drastic changes in the overall business environment, this concept began to be used more aggressively in any value-based assessment and soon became an important element of reports undertaken by consultants. In fact, it was B Stewart III, one of the partners in the firm, Stern Stewart & Co, who published the most popularly used version of this concept of residual income as we know it today. Most of these versions use the same basic formula that assumes that residual income is the difference between the cost of capital and the return on the basic investment in the business. The difference in the various methodologies used to calculate this concept is that they use different kinds of valuation metrics to arrive at this figure.
3. Is Residual Income Passive Income?
Many times, the residual income definition throws up an interesting point. Now we all know that it is that income which you continue to earn or where you continue to get paid long after the work is done. A case in point, as we highlighted earlier, is book or music royalty or even return earned on investment or real estate. So any mode of income that you can continue to earn long after you have completed the task can be classified as residual income. Whether it is derived from invested assets, real estate, it essentially means that though you are an income beneficiary, you are not really associated with the day to day functioning of the business or rather the source of income.
For example, the kind of money that Bill Gates is earning from the Microsoft business though he is not directly involved in the actual operations of the firm can be termed as residual income now.
It is the same way how you can term the money you are earning from your rented property as residual income.
This is exactly why this type of income is sometimes termed as passive income and will almost make you believe that you really won’t have to lift a finger to enjoy this type of benefit. But we all know one basic fact that for any business to remain profitable and worthy of any income generation, you have to constantly keep an eye on it. For example, while the rent from a property would be passive income or residual income, the landlord won’t be able to earn it if he or she does not constantly work towards keeping the property up to date, undertake restoration work and keeps it appealing for tenants to use it and rent it.
The other important aspect is that while the day to day involvement for generating a passive source of income or residual income might not be huge, at some point of time you had to work really hard to establish the source of income as you have it now. It would be rather naive to assume that you never did anything and yet could manage a residual income. The very nature of this source of income highlights the importance of working hard and building assets that can bear fruit at a later date. So then the question would be can everyone build a source of this type of income or is it specific to a certain genre of entrepreneurs only?
4. Ways to Build Residual Income
Well, it is common sense for anyone probing what is residual income; to understand, that the first step to this kind of income is to either generate a service or an asset or a product that can continue to yield returns long after you conceptualized it. Perhaps the best example of that perspective would own a house. At one point of time, you worked hard to generate the extra savings to meet the EMI requirement for your house loan, got the money to get the property registered and also undertook measures to make the house as comfortable as possible. So, at a later date when you leased it out, it yielded returns well above the basic minimum rate.
In many ways, the first step towards attaining this is identifying the right channel for creating an active money source that can be eventually translated into a passive income generator. You possibly cannot generate residual income from a new business that you started just yesterday. You have to first set up the whole business mechanism and gradually work towards scaling back your association and enjoying the residual income.
5. Use of Residual Income
Now that the residual income accounting definition is pretty clear and the concept employed quite distinct, we now embark on the journey to understand the various usage of this key valuation metric. In fact, one of the most pertinent usages can be seen in the world of finances which are very keenly dependent on this basic valuation parameter.
– Personal Finances
This is mostly used in terms of assessing an individual’s residual income. For example, let’s say person X earns $20,000 a month and has to pay tax at the rate of 35%, his take home salary would be $13,000. Now let’s say he also has a $1000 mortgage payment every month and credit card debt accruing to $1000, then his residual income would be $11,000.
Therefore, as you can well understand when anyone is applying for any type of loan, this RI or residual income becomes an important factor to consider and often could be the basis on which an individual gets or does not get loan. This is because any organization which is offering the loan would assess the ultimate residual income that a person is left with and will calculate the potential of his being able to repay a fresh loan on the basis of this key figure.
So supposing the amount of loan that person X is applying for can be met with adequately from the $11000 that he is left with as residual income, his loan application would be granted immediately. This is because the institution will become certain that there is sufficient residual income for the individual to pay back the loan amount.
6. Advantages of Residual Income
That, therefore, brings the whole discussion to the broad benefits of incorporating this key accounting practice and valuation metrics in your overall income statement. Some of the most strategic and important benefits of residual income include:
– Continuous Source of Income
Once you generate the source of income, with just a little bit of care you can ensure that you have a more sustainable source of long-term income. This is no doubt one of its most primary advantages. Of course, the initial effort that you put into this whole resource generation can be rather demanding but at the end of the day, it pays you well. Moreover, once you do not have to devote too much time and energy to this income source, you can use the same energy for pursuing other profitable ventures and earn more money from them.
Moreover, the residual income creates a more or less permanent solution that can be not just enjoyed by you but also your family members. In the case of corporate, this additional revenue can be more actively used for expansion opportunities and hence it can enhance the profitability of the business you are associated with.
– More Flexible
It is also by extension a more flexible form of income. There are different risk profiles for different types of income, and accordingly, the overall tax liability for the risk exposure of an individual depending on those can be quite conveniently adjusted as per needs. Also, this kind of earning method ensures that an individual does not have to stay put in a specific location to earn this, whether it is royalties or house rent. That means not only do they have spare time and money but also mobility to pursue their dreams even well.
7. Disadvantages of Residual Income
However, that does not mean residual income is all gain no loss situation for individuals and corporate alike. Many times, its disadvantages also come to the forefront. These include:
– Uncertain Income Source
Let us assume that you get your residual income from house rent. What if your tenant defaults one month or the check that you deposit bounces? Obviously, you would speak to the tenant and get the matter sorted out but the fact is you cannot wish way this type of uncertainty and you will have to work around this type of inevitability.
– Tax Liability on Dependents
There are special tax rules that are applied to dependents of those enjoying the residual income. According to the IRS regulation, those with access to unearned income of above $950 need to file income tax. Now, the contrast and the pressure that this situation creates can be well understood when you compare this with the tax liabilities of dependents with earned income. For them, there is no provision to earn any tax for income of as much as $5700 or even more in some situation. The tax burden on the dependent is much higher if you have residual income.
Therefore, you can conclude that residual income is that valuation metrics that can easily help you assess the true worth of the income that is being generated after paying your expenses and liabilities. While there are many advantages of this mode of income like funding expansion for business and creating alternate income generation module for an individual, the crux of the matter is that it also creates some uncertainty in your entire budget plan.
— Key Component for Assessing the Right Value
Overall, you must understand that residual income can be a key component for assessing the right value of a firm. But at the same time, it needs to be taken in proper perspective and with all the other parameters under consideration. Moreover, residual income is not the right metrics to decide on the asset purchasing ability of an individual. While you do get an idea of the separable income, at the same time, it does not take into consideration the various other liabilities that might be there.
It is at most considered as a useful option to assess valuation where using the Return on Investment metric might not be possible. This is particularly on situations where there is a conflict between investment decisions and cash flow discrepancy. In those types of situations, residual income can be a great option.
8. The Advanced Meaning of Residual Income
As I explained at the beginning of this article, residual income has got a different meaning than what accountants say. I like this definition a lot more because it makes a lot of sense and it pleases you more. I believe this is exactly what residual income has to mean:
Residual income is the income that keeps coming even if you stop working.
How is that possible?
This is possible through starting the businesses that not only are scalable, which means they can easily be expanded and their income can easily be increased, but also they keep on making money even if you stop working as the business owner and entrepreneur. It is only through the Internet that starting such businesses has become possible.
Then it keeps on making money even if you stop working.
Although, its income will go down gradually if you don’t work on it anymore, but it doesn’t stop as soon as you stop working. Or you create a good digital product like an e-book which is so demanding. Then you start selling it online through the Internet. It keeps making money even when you are asleep or when you completely stop promoting it. The other businesses are not like this at all.
For example, when you have a restaurant that has already cost you thousands of dollars to start and maintain, it won’t make a single cent if you don’t open it one day.
Now, which one is good?
Starting a business that costs you thousands of dollars to start and maintain, it is not clear whether it will make any profit or not?
(It can stop making money if you stop working.)
OR, starting a business that is a lot cheaper to launch, much easier to promote and maintain, and keeps on making money even if you stop working for several months? There is no doubt that you choose the second. Having such a business with such a high income potential and residual income was impossible in the past. But it has become possible and very easy now: What Is Data Technology and How It Can Make You a Millionaire?