Residual income can be split into three categories — personal income, business income, and equity valuation. Personal residual income, also called excess income or disposable income, is money left over after all bills have been paid. This income can be put into savings or spent on non-essential items.
Having residual income can help in getting a loan. It shows that a person has more than enough money coming in every month to pay their bills. This is likely to lead to a loan approval (assuming the person doesn’t have high debt) if the individual can show that their income and bills will remain consistent. The more residual income a person has, the less likely they are to default on the loan. Choosing candidates with higher residual income reduces default risk for lenders.
In business, residual income is (the net) income generated above the required rate of return for the business. It is excess income after the business has paid all of its bills. Technically, it is the operating profit remaining after all costs of capital has been paid. The cost of capital is incurred to generate revenues for the business.
In this way, residual business income is similar to its personal residual income counterpart. However, businesses may invest money and earn additional income that doesn’t require labor or raw materials. It is only the invested capital that is needed to earn additional income. This type of income is also called passive income.
Some examples of passive income include stocks, bonds, royalties, and real estate. All are considered investments. They are not without risks, however. Companies evaluate whether it is worth taking the risk based on the expected returns.
The equity valuation of residual income is basically the same equation we’ve been using: Net income minus the cost of capital (equity charge). To determine the equity valuation, we must look at what goes into the equity charge. It is the value of equity capital multiplied by the cost of equity (required rate of return on equity).