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Sunday, April 21, 2024

What is residual income?

What is residual income?

07.20.2023

Key takeaways

  • Residual income can be calculated for businesses and individuals, but the formulas are different.
  • The ability to generate residual income is key to building wealth for the future.
  • Passive income strategies are some of the best ways to drive increasing amounts of personal residual income.

 

The word residual means the amount left after other parts have been removed. If you're drinking a glass of milk, the glass is never clean once you're done drinking. A little bit of milk coats the bottom and sides of the glass — the residue left behind. 

Businesses and individuals forfeit some income by paying necessary expenses, but the concept and calculations are more complex in corporate situations than they are in personal finance. In both cases, residual income can be an indicator of financial health — or the lack of it — so it's often considered by lenders, investors and others.

How do you calculate residual income?

Businesses calculate residual income differently than households. Check out the formulas for residual income below, along with some examples to help you understand how the numbers break down. 

Residual income formula for corporate finance

The formula for residual income in corporate finance is:

Residual income = Operating income - (Operating assets * minimum required return)

In this formula:

  • Operating income refers to income left over after paying required expenses. The formula for operating income is revenue - expenses. It's also referred to as segment margin or controllable margin in some cases, such as when you are calculating residual income for a specific project, effort or segment.
  • Operating assets are the resources the company needs to have on hand, on average, to keep up with current operations. These types of assets include inventory, cash and fixed assets such as equipment. 
  • Minimum required return is the smallest rate of return that is acceptable for an investment or project. It is included in the formula above as a percentage expressed in decimal format.

To understand the residual income formula for corporate finance, let's look at a specific example. In this hypothetical example, a manufacturing business has invested $500,000 in machines and equipment to produce its products. The company has a revenue of $800,000 for the year in question and has $600,000 in expenses. That brings its net operating income to $200,000. 

The minimum required return the company will accept is 15%. It sets this based on a historical return of 15% and a desire to do at least as well as it has in the past. 

All the numbers required to calculate residual income are included in this scenario:

  • Operating income = $200,000
  • Operating assets = $500,000
  • Minimum required return = 15%

Let's plug these numbers into the formula for residual income in corporate finance:

  • $200,000 - (500,000 * 0.15)
  • $200,000 -  $75,000
  • Residual income = $125,000

Assuming this business earns at least the minimum 15% return, it has at least $125,000 of residual income. This money can be set aside as cash assets for the future, reinvested to support growth, issued as dividends to investors or used for other business matters.

Residual income isn't always positive, though. Consider another example. The operating assets and minimum required return are the same, but in this example, imagine the business had revenue of $600,000 and expenses of $550,000. The operating income is now only $50,000.  The formula would work out as:

  • $50,000 - (500,000 * 0.15)
  • $50,000 - $75,000
  • Residual income is -$25,000

When residual income is negative, it means that the business doesn't have an income high enough to support its investment. It may mean that the business doesn't make enough to continue operating long term without some significant changes. 

Residual income for personal finance

The formula for residual income in personal finance is:

Residual income = Income - Necessary expenses

In this concept, residual income is also referred to as discretionary income. It's the amount you have left over after you cover necessary bills, such as your mortgage or car payment. Personal residual income lets you know how much money you have to cover your lifestyle expenses, save for emergencies or upcoming events, or invest for your future.

Your personal residual income can also be a factor in whether you can get approved for some types of credit, especially mortgages.

The concept of personal residual income is less complex than business residual income, but here's a quick example to make it clearer:

  • Jonah earns $6,000 a month.
  • He has a mortgage payment of $1,100, a car payment of $500 and other debt payments totaling $800 each month.
  • Jonah's residual income is $6,000 - ($1,100 + $500 + $800). 
  • Residual income in this case is $3,600.

If you want an even more accurate picture of true residual income, you might also subtract utility and insurance payments, taxes, groceries, fuel and other necessary expenses to determine what's left to fund savings, investments and optional purchases.  

A note about passive income 

Some people use the term "residual income" to mean "passive income." Passive income refers to income that you earn without additional effort. If you're a nurse who gets paid $28 per hour, those hours' wages are not passive income because you are actively working for the wages. If you invest money and earn 5% returns, those returns are passive. 

Why is residual income important for building wealth?

Having some personal residual income is important for building wealth because you can allocate that money to saving and investments. If you have no residual income or negative residual income, you're using all of your income resources to make ends meet and won't have anything left to start building wealth.

The earlier you can create residual income, the greater your potential for long-term wealth creation. Consider this example:

Someone who is 20 years old is able to generate $500 in residual income every month. They put it in an investment that earns an average return of 6%, reinvestment of earnings and no withdrawals. Every month for the next 20 years, the person takes $500 of their residual income and puts it in this investment. By the time they are 40 years old, they have $229,426.  Please remember that hypothetical illustration does not reflect a particular investment and is not a guarantee of future results. Rates of return may vary. The illustration does not reflect fees, which could change the outcome provided.

Tips and strategies for building a residual income

Building residual income is possible, but it's not always easy.

Here are a few things to keep in mind to help support success:

  • Diversify. Avoid sinking all your efforts into a single income strategy. If you're buying and flipping houses as your only income-generation strategy and the housing market falls apart, you might be left holding a lot of expenses. Spread your efforts over multiple strategies including a diversified investment portfolio.
  • Engage in risk management. Take time to analyze your investment and income opportunities and understand the risks you might face. When you understand the potential for loss in an investment, you can proactively plan to help minimize risk in order to safeguard your big-picture strategy.
  • Be consistent and patient. Residual income tactics usually entail small gains over long time periods – not get-rich-quick schemes. Once you settle on your plan, try to stick to your long-term vision.  
  • Reinvest your earnings. It can be tempting to take early residual income and splurge on nice things or adventures. Enjoying life is important. Be sure to balance that with reinvesting your earnings in your long-term goals. 
  • Seek professional advice. Consider working with a financial professional to understand the best way to increase your income and invest in your future. 

Our take on residual income

Residual income is an important factor for businesses and individuals. Your personal residual income can make a difference in the types of loans and other offers you qualify for, and the more residual income you have, the better you can invest in wealth building for the benefit of your future self.

Want a better way to manage your money? Our free money tools bring your accounts together in one place so you can monitor your investments and plan for your big financial goals.

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Asset allocation, diversification, and/or rebalancing do not ensure a profit or protect against loss.

The Currency editors

Staff contributors

The CurrencyTM, a publication from Empower, covers the latest financial news and views shaping how we live, work, and play. We keep you current on ways to plan, save, and invest for life.

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