Residual Income

Category: Financial.

Residual income refers to the amount of money that is left after all the expenses have been paid for a period. The residual income can be on a personal scale or on a business scale. Both of them have different formulas. To understand better the residual income calculation, this is also named discretionary income.

Banks also use this ratio to calculate exactly if a person could afford a loan. After a person pays its existing bills, the bank calculates exactly if the residual income is enough for that person to afford a loan. The higher the residual income, the higher the chances for the loan to be approved. If the residual income is low or close to zero, then the loan will surely be rejected.

In the business part of the residual income, accountants define this term as the number of operating revenues left over from a department or a whole company after the cost of capital has been paid. To get a better understanding of the whole principle and the formulas themselves, below you can find the whole explanation.

Personal Residual Income Formula

The formula is a basic subtraction. Just subtract the monthly debt payments from the monthly take-home pay. So in the end, the formula will look like this:

Residual Income
=
Monthly Take Home Pay – Monthly Debt Payments

As per the above statement, banks use this formula more often to see if the person could afford a loan.

Although the personal residual income formula can’t be used to calculate the income for a bank, accountants have developed a formula for the business side. It’s still a subtraction, but with a slight difference.

Business Residual Income Formula

This piece of calculation is crucial for a business, because it may tell if a business can close, maintain, or continue to invest more for profit. For example, if a company invests revenues for a certain department, the company should receive a 15% return from the investment. If the investment exceeds 15%, then the company is recording a profit and could invest in more assets. If the residual income is lower than 15%, then the department will be closed or redirected to other investors.

The formula is simple with a slight change versus the personal residual income.

Residual Income
=
Net operating income – (Minimum required return X Cost of Operating Assets)

Final Thoughts

To conclude the above information, residual income is a life saver somehow. Another example is when you quit your job at a certain point, but you still receive money for the work you’ve done last month. This is the best real-life example. Another famous example is of Bill Gates that receives money from Microsoft, although he isn’t in the company anymore. Even a CEO of a company that called it quits can receive residual income from just giving advice to the new CEO. Some accountants may call this income a passive income because there is no job active when you receive the money. Keep in mind that for a residual income, you must have an active income as well; otherwise the residual income will not be available.

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