You do a job, you get paid. That’s how most of us think about making money. However, there are ways to grow wealth beyond your paycheck. Residual income is a crucial part of your path to long-term financial stability and wealth building.
Let’s say each month you earmark a certain portion of your take-home pay to cover necessities. You pay your rent or mortgage, manage auto loans, and keep your household afloat. Once those expenses are covered, you have money left over to use at your discretion. That money is residual income.
Residual income isn’t just valuable because you can spend it however you want. Residual income matters because it can gauge long-term financial stability. Companies or investors use residual income to evaluate business prospects, and individuals use residual income to bolster loan applications or make investments.
What is residual income?
Residual income refers to the portion of your income left over after necessary expenses. It’s sometimes also referred to as discretionary income. You can spend it on things of your choosing.
To calculate it, add your bills and long-term debts for each month. Then subtract those expenses from your take-home pay. Whatever’s left over is your residual income.
Residual income is especially important when applying for loans. If you have enough money to cover expenses and still have some funds left over, you’ll have a better shot at being approved for a loan. Residual income also gives you the chance to pursue other investments that might grow more wealth over time.
The term residual income is sometimes used interchangeably with passive income. But they aren’t the same thing.
Residual income vs. passive income
Whereas residual income is leftover money, passive income is a stream of income generated by work you’ve already done or investments you’ve already made. Royalties are an example of passive income.
Residual income can come from active income (e.g., earning a paycheck) or passive income. For example, if you make $3,000 per month in royalties from a book you published, and you use $2,000 of that money to pay for your necessary expenses each month, you have $1,000 of residual income made from passive income. Residual income can also come from active income (e.g., earning a paycheck).
Often, one of the most efficient ways of generating passive income is investing. Investing in the market—that includes stocks, ETFs, or bonds—is one of the simplest ways to earn passive income. Some investors choose to pick their own securities to invest in; others opt for a managed investment solution, in which expert financial analysts invest their money for them. Learn about Titan’s managed investment solution.
Other means of generating passive income include: renting your property, running an affiliate-linked blog, setting up an e-commerce shop, or producing works which receive royalties. Each of these comes with its own set of considerations and up-front costs, which is why actively-managed investment portfolios are often the right choice for individuals with limited time to devote to passive income streams.
Types of residual income
Residual income has applications outside of personal finance. The two others are:
- Corporate finance
- Equity valuation
Residual income in corporate finance
Here, residual income measures leftover operating profit after all costs of capital to make revenue are paid. It can also refer to any profit that exceeds the company’s expected rate of return. In this context, residual income is important because it can show you how well a project is performing.
How to calculate a company’s residual income (RI)
In this case, you need to consider the expected minimum rate of return, the project or investment’s profit, and the amount of capital set aside for the project. The residual income formula would be:
RI = Income - (Required Return x Investment)
Here’s an example. You’re trying to evaluate if a specific product line is generating residual income and that division makes $400,000 in profit. The division needs a minimum rate of return of about 10 percent, and you’ve allocated $100,000. The formula would be:
RI = $400,000 - (.10 x $100,000) = $390,000
This division has a positive residual income, so it is exceeding the required rate of return expected by management. That’s good. If its residual income value were negative, that would be a sign the division was underperforming.
Residual income in equity evaluation
Here, residual income can help determine how much a company’s shares are worth. Residual income is key because even if a company looks profitable, it may not be. Calculating residual income can uncover the truth.
How to use residual income to evaluate equity
To perform an equity evaluation, you need to grasp the concept of Equity Charge, or the amount of capital allocated to a project, multiplied by the required rate of return (which allows you to account for the opportunity cost of taking that capital elsewhere).
Imagine investing $600,000 in Company X, with a required rate of return of 10 percent. Your Equity Charge would be:
Equity Charge = $600,000 (.10) = $60,000
To calculate residual income, subtract the Equity Charge from the company’s net income. Let’s assume that Company X makes $55,000 per year. The formula for residual income would be:
RI = Net Income - Equity Charge
RI = $55,000 - $60,000 = -$5,000
Given the cost of capital, this company may not be that profitable. That’s a red flag for shareholders, but you can’t know the value of this company’s shares without doing a full calculation, which factors in potential residual incomes and the company’s book value.
Building residual income
To maximize residual income, your income should exceed your expenses, and you’ll want to keep your debts as low as possible. Investing your money wisely can increase your overall income, and help you build residual income. Learn how Titan can help you meaningfully expand your wealth, by actively managing your investments and keeping you informed throughout the process.