Understanding Residual Income: Pathway to Financial Freedom
Residual income is the money that continues to flow after an initial investment of time and resources has been completed. Examples of residual income include artist royalties, rental income, interest income, and dividend payments.
The term residual income is used in various contexts:
- In personal finance, residual income can refer to an individual’s discretionary income, or the total amount of money left over after paying all personal debts and obligations.
- In corporate finance, residual income is a measurement of corporate performance that reflects the total income generated after paying all relevant costs of capital.
Key Takeaways
- Personal residual income isn’t generated by hourly wages. Rather, it requires an initial investment of money, time, or both with the primary objective of earning ongoing revenue.
- Residual income is often referred to as passive income.
- Sources of residual income include real estate investing, stocks, bonds, and royalties.
- Corporate residual income is leftover profit after paying all costs of capital.
How Residual Income Works
Residual income broadly speaking is a measurement of tangential profits earned after subtracting all costs of capital related to generating that income. Other terms for residual income include economic value-added, economic profit, and abnormal earnings.
Although residual income can also be passive income, side hustles are another excellent way to boost personal residual income.
Types of Residual Income
Stock Valuation
Residual income also serves as a valuation method for estimating the intrinsic value of a company’s common stock. It accounts for the cost of capital, meaning the combination of debt and equity expended to finance the company’s operations.
The residual income valuation model values a company as the sum of book value and the present value of expected future residual income. Residual income, in this context, is the profit remaining after the deduction of opportunity costs for all sources of capital.
Formula:
Residual Income = Net Income - Equity Charge
Corporate Finance
In managerial accounting, residual income is the amount of leftover operating profit after paying all costs of capital used to generate the revenues. It is also considered the company’s net operating income or the profit exceeding its required rate of return.
Formula:
Residual Income = Operating Income - (Minimum Required Return x Operating Assets)
Personal Finance
In personal finance, residual income is synonymous with monthly disposable income. It’s the total income that remains after paying all monthly debts, often crucial for loan applicants.
How to Generate Residual Income
Most sources of residual income require an upfront investment of money, effort, or both. Here are some effective methods:
- Buy Bonds: Once the bonds are purchased, the owner has a stream of cash available until the bonds reach maturity.
- Buy a Rental Property: Renting out a second home or investment property is a solid way to add to your income with minimal effort post-initial investment. If you lack seed money, consider renting out a spare bedroom.
- Invest in Index Funds: Your profits can grow over time even if you don’t actively manage your investment.
- Peer-to-Peer Lending: The internet provides various avenues for residual income like peer-to-peer lending platforms, where you can facilitate personal unsecured loans at competitive interest rates.
- Sell Your Stuff: Engaging in side gigs via platforms like eBay or Etsy can help you earn extra income by selling unused items or monetizing a hobby.
Residual Income vs. Passive Income
The subtle differences are important:
- Passive Income: Earned with little to no effort required after the initial investment.
- Residual Income: For an individual, it means the free cash available for spending after all obligations are met.
Is Residual Income Taxable?
Yes, almost all forms of residual income are taxable except for some tax-exempt bonds. Income from stock dividends, rentals, etc., are generally taxable.
Why Is Residual Income Important?
Residual income is often passive income, which can be relatively effortless. Think stock dividends and bond premiums. To quote the legendary investor Warren Buffet: “If you don’t find a way to make money while you sleep, you will work until you die.”
How Do I Calculate My Residual Income?
If you are applying for a loan, your residual income is the amount of money left after all your monthly obligations have been met (also known as discretionary income). When planning for the future, residual income accounts for the money you generate or plan to generate from passive sources like dividends and interest.
The Bottom Line
Residual income is not free money. It requires an upfront investment of money, effort, or both. However, once that work is done, a stream of income is established that requires little to no effort to maintain.
Related Terms: economic profit, discretionary income, cost of capital, equity charge, opportunity costs, stock valuation, operating assets, minimum required return.
