What Is Residual Income? Definition and Types
By Ellis Burgin
Updated May 10, 2022 | Published February 4, 2020
Updated May 10, 2022
Published February 4, 2020
Ellis Burgin is a seasoned content writer with extensive experience in finance, accounting and management.
Residual income can help you set attainable financial goals and budget money wisely. Both professional organizations and individuals can calculate and analyze their residual income. Learning about this concept may help improve your financial planning abilities and develop your knowledge of common accounting practices. In this article, we define residual income and how it differs from passive income, list the types of residual income and explain how to create it.
What is residual income?
Residual income is the amount of money an individual or business has left after paying all expenses. Personal residual income is any remaining money after an individual pays all housing, food and other expenses and pays off debts. A company's residual income is the capital leftover after they complete all their financial obligations, such as the cost of raw materials and utilities. It signifies, and is utilized to measure, the performance of a business, a department within it or even certain investments made by it.
Overall, the more residual income you have, the more financial freedom you have to achieve personal financial goals or scale your employer's business and make choices that benefit internal and external stakeholders, such as investors or employees. It also gives companies the chance to evaluate their key performance indicators to see if they can be altered to track the success of the company.
Residual income is calculated using the following formula:
Residual income = Net income - (Equity x Cost of equity)
Net income is earnings after all expenses, costs, interest accrued, depreciation, amortization and taxes.
Equity is the total assets minus the total liabilities enumerated on the balance sheet.
Cost of equity is the minimum return required on an investment.
How is passive income different from residual income?
Residual income and passive income are somewhat similar concepts for businesses and individuals. Although, there is one key difference between the two concepts: Residual income, by definition, is not a type of income directly generated by an organization. Residual income refers to the calculation of a company's financial outcomes to measure operating performance—that is, to see if they're paying the bills or to track how much money they have leftover that can be used to improve the business. In the business world, passive income alludes to the accumulation of capital earned by a company with little effort required to get it. In personal finance, however, passive income typically describes income generated from a side hustle or investment like real estate.
Types of residual income
In business, residual income is conducive for a continuous improvement strategy because residual income helps free up time to strategize how to expand operations. The following are different types of residual income that can be a part of a company's financial obligations:
Real estate investing: Purchasing a rental property is a type of residual income because you're doing all the work upfront. By renting out the property to tenants, you can accrue income each month with the rent payments you charge for the property. You can also invest a certain amount on a property and become an owner once it's fully funded. This way, you can budget your investment and make plans to finance it in the meantime so your company can still be solvent.
Stocks: The stock market provides a lot of opportunities to make a profit for your company that you can report as equity on your balance sheet. The more money you make from an investment, the more residual income you'll collect. Index funds are a way to make investments in multiple stocks gathered in a single fund, and your profit can accumulate without additional effort provided on your end.
Bonds: Bonds help you have an ownership stake in loans taken out by companies and governments. Investors receive fixed-rate interest payments about twice a year. Once a loan matures, then you can reinvest in other bonds to have consistent cash flow coming in and out of the business. However, you're still making money and not directly putting in the effort at each step of the process.
Royalties: A royalty is an amount of money that goes to the owner of a product or patent by those using that product or patent on an ongoing or one-use basis. It could be assets, intellectual property, resources or copyrighted material. The amount you receive in royalties is the income you receive after you do all the work necessary up front for the product to be on display.
Read more: 3 Types of Income: Definitions and Examples
How to create residual income
Review these steps for creating residual income in a business environment and use it to your advantage:
1. Review your balance sheet
Your balance sheet determines the available assets you have after you subtract liabilities from your equity. You can use the result to determine the state of your employer's finances. You may assess how your company is earning money before you can adjust and improve those asset-making procedures.
2. See if your profits result from active income
Active income is the income you earn by participating in each step of the process to make money from a provided service. Employee wages and salaries can reflect the amount of active income your employer generates. If your employer generates income solely from active income, then measures you can take to increase your profits through residual income.
3. See if your profits result from residual income
Review the types of residual income to see if they've contributed to producing income for your employer. Larger businesses or corporations normally invest widely in stocks, bonds and real estate to maintain their financial health, whereas small businesses tend to be more selective in their investment strategies.
Also, creative individuals may be working on their own to get their artwork published and receive royalties for it. For example, musicians can sign with record companies, who get royalties from the music they promote on behalf of the musician.
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