Residual Income (RI) is calculated by subtracting the minimum required return on operating assets from the operating income. Here's a breakdown:
The Residual Income Formula
The formula for calculating Residual Income is:
Residual Income = Operating Income - (Minimum Required Rate of Return x Operating Assets)
Where:
- Operating Income: The profit generated from the core business operations (also known as Earnings Before Interest and Taxes, or EBIT).
- Minimum Required Rate of Return (MRRR): The minimum percentage return a company expects to earn on its investments (also known as cost of capital). This is usually determined by management and considers factors like risk and opportunity cost.
- Operating Assets: The assets used to generate operating income. This typically includes items like cash, accounts receivable, inventory, and property, plant, and equipment (PP&E).
Understanding the Components
Let's clarify each component:
- Operating Income: This reflects the profitability directly attributable to a company's operations, before considering financing costs (interest) or taxes. It is the profit before interest and taxes (EBIT).
- Minimum Required Rate of Return (MRRR): This is the hurdle rate that the company must clear to satisfy investors. It represents the opportunity cost of capital. For example, if the minimum required rate of return is 10%, it means investors expect at least a 10% return on their investment in the company.
- Operating Assets: These are the assets actively used in generating the company's revenue and income.
Step-by-Step Calculation
Here's how to calculate Residual Income:
- Determine Operating Income: Identify the company's operating income from the income statement.
- Determine Minimum Required Rate of Return: This rate is usually predetermined by the company's management.
- Determine Operating Assets: Calculate the value of the company's operating assets. This might involve averaging the beginning and ending balances for the period.
- Calculate the Minimum Required Return: Multiply the minimum required rate of return by the operating assets.
- Calculate Residual Income: Subtract the minimum required return from the operating income.
Example
Let's say a company has the following information:
- Operating Income: $500,000
- Minimum Required Rate of Return: 12%
- Operating Assets: $3,000,000
Here's how to calculate the Residual Income:
- Minimum Required Return: 12% x $3,000,000 = $360,000
- Residual Income: $500,000 - $360,000 = $140,000
In this case, the Residual Income is $140,000. This means the company exceeded its minimum required return by $140,000.
Interpreting Residual Income
- Positive Residual Income: Indicates that the company is generating more profit than the minimum required return. This is generally a good sign, suggesting efficient use of assets and value creation.
- Negative Residual Income: Indicates that the company is not generating enough profit to meet the minimum required return. This may suggest inefficient use of assets or a need to improve profitability.
- Zero Residual Income: Indicates that the company is generating exactly the minimum required return.
Why is Residual Income Important?
Residual income is a valuable tool for:
- Performance Evaluation: It helps assess the performance of divisions or investment centers within a company.
- Investment Decisions: It can be used to evaluate the profitability of potential investments.
- Strategic Planning: It helps managers make decisions that will increase shareholder value.
Residual income provides a more comprehensive view of profitability than simply looking at net income or return on investment (ROI) because it considers the cost of capital.
