In the world of finance residual income is probably best known as the money people involved in the arts make off of their works. You may have heard or read of an artist getting a residual check for a piece of music or some other form or art. The best way to imagine this is by thinking of your favorite ‘90s movie and imagining that every time that movie runs on TV, the people that stared in it get a check in the mail. The same principal applies to anybody that has made an investment in stocks in companies that are now in the top of Fortune 500. But any financial analyst will tell you that there’s a lot more to it than just that. When going online and typing “what is residual income” you get a ton of links explaining what the term means and how you can manage yours, but really understanding what they’re saying and choosing the best solution for your particular situation requires a little more research than just reading whatever link pops up first.
What Is Residual Income?
The fastest way to answer the question what is residual income is to say that this is the income one is left with after deducting all the debts one has from his or hers monthly paycheck. But this is only relevant for personal finances. In the world of corporate management, this income reflects the income a company has relative to that company’s required returns. It’s basically the same thing as in personal finances, but a lot more analysis and special terms are involved.
When speaking about personal finances, this type of income is also known as passive income. The beauty of the concept is that you can, depending on your area of interest, basically make money without needing a 9-to-5 job. That doesn’t mean you should quit the one you have. Granted, there are some drawbacks to this kind of income. For instance, you may not always have a steady flow of money. Some months could be better than others and there is always the very real possibility that your investment will stop producing. Even so, there are a lot of people out there making this passive income thing work for them and for their families.
How Does Residual Income Work?
Residual income isn’t really an income at all. The term is mostly used in financial institutions and analysis to determine the amount of debt a person can handle. For instance, if somebody would like to take out a mortgage, the bank offering this service will firstly take a look at an applicant’s residual income before signing any contract with him.
They do this by subtracting any other debts the client might have such as credit card payments or student loans. After that, the actual mortgage installments are subtracted, plus several other operating fees, insurance and other taxes. The amount left is then compared to what it means to live in a certain area. As you very well know, some cities or towns are more expensive to live in than others. If the amount is enough to live off of, then the bank will grant the mortgage.
The Three Types of Residual Income
Although the term is kind of self-explanatory, when asking ”what is residual income?” you will get different answers depending on who you ask. In personal financing the definition is pretty strait forward. It is the amount of money left over after paying your bills every month and after buying whatever you need in order to survive. It is the disposable amount of money you have that you can spend or invest.
But the definition starts to get a little more complicated when talking about the corporate world. Take equity valuation for instance. This is a way for companies to know how much money they make after deducting all the costs of making the money. Because it involves subtracting a capital charge from the net income of the company, some companies can have a positive net income although having a negative residual one.
When talking about corporate finance, the method of calculation changes a bit. First they multiply the minimum required return, which is what the company has to make in order to stay afloat, with the operating assets. The resulting number is then subtracted from the operating income of the company. This sort of calculation is usually used in order to assess the performance of a team or a department in a business unit.
