Residual income provides a valuable analysis tool for both company managers and its investors, allowing them to measure how profitable the company or certain activities performed by the company are. Negative residual income indicates a lack of profitability, even if the company is recording a positive net income on its financial statements.
Residual income indicates whether a company, division or even a project is operating profitably. A company’s residual income is the company’s net income minus the cost of any capital used by the company. Residual income also takes any assets owned by the company into consideration. Investors also use residual income to assess the performance of a company and determine the company’s financial direction.
Some may think that net income alone indicates the profitability of a company; however, a company may earn a positive net income and yet still have a negative residual income. Positive net income and a negative residual income may indicate that the company is not profitable, or has little profitability. Higher ratios between a company’s net income and residual income indicates more financial health for the company. By measuring the ratio between net and residual income for a company regularly, you may measure whether a company is becoming more profitable over time.
To figure out a company’s residual income, subtract the company’s cost of capital from the company’s net income, and then multiply the difference by the company’s total assets. When the company’s residual income is a negative value, it means the company is not profitable even if it is netting a positive income. Calculating the company’s residual income shows whether the company is becoming more or less profitable with time.
A negative residual income may drive some investors away because it indicates the company is not profitable at the present time. In a publicly held company, investors or stockholders may move to replace management if the company’s residual income does not show improvement over a specified period of time. In large corporations, a division or department in the company may have a negative residual income, prompting management to enact reforms or to outsource certain company functions.