Residual Income: Definition, Ways to Earn It, Examples

Residual income refers to the amount of disposable income left after paying all personal debts and obligations. In corporate finance, residual income is the profit remaining after accounting for the cost of capital. This is different than passive income, which refers to income that is earned without any active involvement.

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What Is Residual Income?

In personal finance, residual income is the money left after all personal debts and major expenses are paid. This remaining amount can help assess an individual’s ability to take on new loans or investments.

In the corporate world, residual income measures a company’s profitability after accounting for the cost of capital. It’s the profit left after paying all costs, including the cost of equity and debt, making it a valuable metric for evaluating corporate performance.

Residual income can come from different sources. Here are three to keep in mind:

1. Stock valuation: Using residual income as a valuation method helps estimate the intrinsic value of a company’s common stock by considering the cost of capital, making it a comprehensive tool for stock assessment.
2. Corporate finance: Managerial accounting utilizes residual income to evaluate a company’s profitability after accounting for the cost of capital. It aids in evaluating the performance of investments, teams or departments within a company.
3. Personal finance: Here, residual income simply refers to a person’s disposable income after covering their debts and living expenses.

Residual Income vs. Passive Income

Both residual income and passive income can refer to earnings that are received regularly, with little to no effort required to maintain them. But, they also have important distinctions. While residual income may be passive, not all passive income is residual. However, residual income can be invested to earn passive income.

Residual income provides a snapshot of your financial health by showing the disposable income available after obligations; passive income focuses on wealth generation with minimal effort.

Passive income is earned with little or no effort required after the initial investment, such as stock dividends, bond interest or rental income from a property. That isn’t always the case for residual income, which can come from any source regardless of the time, energy and investment needed.

For example, residual income may come from the earnings of ongoing freelance work where payment continues for completed projects. This is different from employment wages in that it involves earnings generated from previous work or investments. Employment wages are typically earned through ongoing active participation in work activities.

Potential Sources of Residual Income

There are many sources that can contribute to residual income. Here are four common examples:

• Dividends from investments: When you invest in stocks or mutual funds that pay dividends, you receive a portion of the company’s earnings regularly. After the initial investment, these payments continue with little to no additional effort required, contributing to your residual income.
• Royalties from intellectual property: Authors, musicians and inventors often earn royalties from their creative works. Once a book, song, or patent is created and sold, the creator receives ongoing payments based on sales, usage or licensing agreements.
• Rental income: Owning rental property can provide a steady stream of income. After the initial setup and costs associated with maintaining the property, rental payments from tenants contribute to your residual income each month.
• Business income: If you own a business that turns a profit after you’ve accounted for expenses, it will contribute to your residual income.

Bottom Line

Residual income plays an important role in both personal and corporate finance, offering a lens through which to evaluate financial health and profitability. In personal finance, it signifies the discretionary funds available after meeting all obligations, aiding in financial planning and loan assessments. In the corporate sphere, it serves as a key metric for profitability, accounting for the cost of capital and guiding investment decisions.

Understanding the nuances between residual and passive income is essential for effective financial management, as each type of income provides unique benefits and insights.

Money Management Tips

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