Residual income can be defined as the income left out after subtracting the minimum rate of return from what is being gained. In other words, it means an excess of the minimum rate of return. With regards to personal finance, it means the amount left over after paying the taxes, dues, personal debts and the expenses. In the banking sector, residual income is like a number or figure that banks calculate or analyses before allowing a mortgage to applicants. Banks check it to identify whether the applicants can afford it. The calculation of residual income in banks involves determining the health of the profits of applicants and the claimed mortgage amount. Banks try to identify whether the applicants will be able to make the repayments. The calculation involves the anticipated mortgage amount, taxes and property insurance. If the applicants have to pay for credit cards, the amount paid monthly will also be subtracted from its actual income. By subtracting all these from the income, the applicants' eligibility is checked for the mortgage. On satisfactory outcomes, applicants are allowed the mortgagees. The process of mortgage application might be very challenging for the applicants. It is because their job nature or personal business will be checked for its credibility. The purpose will be to identify whether repayment is assured in any circumstances.
Apart from the things mentioned above, banks check the cost of living for the particular area the applicants reside in. They do it to determine whether the applicants' budget and income are too tight to handle a mortgage repayment. Applicants being able to save a healthy amount every month after deducting all expenses from the net profit will easily be eligible for a mortgage.
Residual income concerning equity valuation has a different meaning. Hence, residual income is a stream of economic earnings and a valuation method for estimating the stock value. The residual income in respect to a company is calculated by determining its sum of book value and the current value of the expected residual income of the future.
Residual income should not be mistaken with a type of income. Instead, it is a kind of calculation facilitated to determine the level of discretionary money, which is available after meeting the financial obligations.
For management accounting, residual incomes will be any income gained after deducting the opportunity cost of the capital being invested from a department's total revenue. It can be calculated separately for a product or service by subtracting its entire value from the gained income. It is to be borne in mind that residual income is taxed. It is taxed in the same way as for earned income. The amount to be paid depends on the adjusted gross income and federal tax bracket. Besides, the calculation should also involve the bracket for state and local taxes. In case, all these apply to a person, he or she will have to pay for the residual income.
Residual income can be utilised in various useful investments. These investments will produce many benefits to the beneficiaries. Some of these are real estate, dividend stocks, peer-to-peer lending, investing in coffee, ATMs, investing in coconuts, rent a room, write a book and others.
Residual income can be used for approval or rejection of an investment. If a person is left with the right amount of residual income and that all the dues, taxes and other kinds of payments are being made, then the remaining amount can be used for valuable investments. The investment will solely be the responsibility of the person with an excess of residual income. Those who struggle to gain residual income, they should invest in useful activities to ensure good returns. Some of these activities are starting a YouTube channel, building an app, earning a residual income with a credit card, trying with index funds and so forth.
Few ideas can be utilised to boost up the residual income. Some of these are considered investing, writing a book, crowdfunding real estate, building an online course and few others. Residual income delivers many advantages to a person. It takes into consideration the opportunity cost used for tying up assets in the division. The minimum rate of return can be different in the diverse situation as it varies depending on the riskiness of the division. Notably, different assets can be needed to be able to earn returns.
Residual income is advantageous and meaningful for a person who continues to make money or has created some assets to maintain the income. Bill Gates, for example, is not any more doing physical work; however, he is still making money from his assets. A surplus of net income after deducting every expense from it means the person is left with residual income. The higher the residual income, the better and more will be the advantages. Residual income will encourage investing in useful and profitable activities. One of the significant disadvantages of residual income is it can never be used in evaluating investments of different sizes.
Residual income valuation is generally suitable for companies that do not pay out dividends and instead follow unpredictable patterns for paying the dividends. In all these cases, the residual income model will be a highly feasible alternative to the DDM (dividend discount) model. Besides, residual income works perfectly with companies that struggle to generate positive cash flows. However, the financial analyst must be aware of a fact that such initiatives are based mainly on forward-looking assumptions. Such assumptions can be manipulated. These assumptions can also have various biases.
Residual income valuation, along with the DCF (discounted cash flow) model, is one of the most recognised and highly practised valuation models in the industry. Residual income approach might be known less to people; however, it still can be used in the investment research. Hence, it can be expressed mathematically using the below-mentioned formula;
Residual Income = Net Income – Equity Charge
Equity Charge = Equity Capital * Cost of Equity