Question

What is residual operating income? What return on net operating assets does a company have to generate to earn positive residual operating income?

Answer 1

Residual Income is nothing but the income earned above the minimum rate of return.

For example, XYZ company has invested an average operating assets of $1,000,000 and expects a minimum return of 10% on it. For the year end, the company has reported $120,000 of income. In this case, residual income will be $20,000 since company has earned $20,000 above the minimum expected income of $100,000 ($1,000,000 * 10%).

To make positive residual operating income, Company needs to generate the rate of return thay is above the required rate of return. Required rate of return for a debt based company can be cost of capital and for equity and debt based company, it will be weighted average cost of company.

After all the costs of capital i.e. Interest, Dividend etc. are paidout, the leftover positive income will be the residual operating income.