Residual Income (RI)

Definition of Residual Income

Residual income (RI), also known as economic profit or economic value added, is a measure of a company's profitability that takes into account the cost of capital. Unlike traditional accounting-based measures of profitability, such as net income or earnings per share, residual income is a more comprehensive measure of a company's financial performance that considers the opportunity cost of capital.

Before understanding the concept and working of residual income along with the examples, it is necessary that we understand the concept of an investment center. Investment center is a division within a business much like a cost center or a profit center. The only difference is that the performance of the manager of the investment center is assessed based on return on investment (ROI) of the division or the Residual income (RI). The use of residual income is usually to assess the performance of a manager of the investment center.

Residual income is also referred to as the net operating income generated by the investment centre. This income is the income in excess of the target minimum return. This means that a residual return is the excess return over the investment return.

The concept of residual income is based on the economic principle of opportunity cost. Opportunity cost is the cost of foregone alternatives, or the value of the next best alternative that is forgone in order to pursue a particular course of action. In the case of a company, the opportunity cost of capital is the return that could be earned by investing capital in alternative projects or opportunities of similar risk.

Residual Income Formula and Calculation

Residual income is calculated by the following method:

RI = Operating Income - (Operating Assets x Target Rate of Return)

This method (RI) is an alternative approach to calculate the performance of the investment center. This method is used in comparison to the return on investment (ROI) method. The formula of ROI is:

ROI % = Operating Income / Operating Assets

The other approach to calculating residual income is as follows:

Residual Income = Net Income - (Cost of Capital x Capital)

Where:

• Net Income = Operating income after taxes
• Cost of Capital = Weighted average cost of capital (WACC)
• Capital = Total capital employed by the company

WACC is a weighted average of the cost of debt and the cost of equity, where the weights are the proportion of debt and equity in the company's capital structure. The cost of debt is the interest rate that the company pays on its outstanding debt, while the cost of equity is the return that investors require to invest in the company's stock.

This clearly shows that assessing the performance of the investment center with residual income (RI) is a better option since it provides a better analysis, and it is better for managers of the investment center to adopt RI when gauging a potential project since it increases the profitability of their division.

While using the residual income as the tool to add performance, the focus is to maximize the income from the project and not the increase in returns. It is also better to use residual income in the undertaking of the new project because the use of ROI will reject any potential projects. The reason for this is that ROI yields lower returns on the initial investment whereas the residual income will maximize the income and not the return on investment.

Economic value added (EVA) approach is an adaptation of the residual income. However, since it is a complex terminology and requires a better understanding of categorizing the expenses as the capital expense, this will be best understood after clearing the concepts related to residual income. 

Advantages of the Residual Income Metric

There are several advantages to using residual income as a measure of a company's profitability. First, residual income accounts for the opportunity cost of capital, which traditional accounting measures do not. This means that residual income provides a more accurate picture of a company's financial performance, since it considers the return that could be earned by investing in alternative opportunities.

Second, residual income provides a long-term perspective on a company's profitability. Unlike traditional accounting measures, which focus on short-term profitability, residual income takes into account the long-term value created by a company's investments.

Third, residual income aligns the interests of shareholders and managers. Since residual income is based on the opportunity cost of capital, it encourages managers to invest in projects that generate a return that exceeds the cost of capital. This incentivizes managers to pursue profitable opportunities that create long-term value for shareholders.

However, there are also some limitations to using residual income as a measure of a company's profitability. One limitation is that it requires a reliable estimate of the cost of capital, which can be difficult to calculate accurately. Additionally, residual income may be influenced by non-operating items, such as gains or losses on investments or foreign exchange transactions.

Residual income, which considers the opportunity cost of capital, is a useful instrument for assessing a company's financial success. In comparison to traditional accounting measurements, it offers a more thorough and long-term perspective on a company's profitability and aligns the interests of shareholders and managers. When utilizing it as a gauge of a company's financial performance, one should, however, be aware of its limits.