Residual Income

Economic Value Added (EVA) is an estimate of true economic profit after making corrective adjustments to GAAP accounting, including deducting the opportunity cost of equity capital. EVA can be measured as Net Operating Profit After Taxes(or NOPAT) less the money cost of capital. Money cost of capital refers to the amount of money rather than the proportional rate (cost of capital). The amortization of goodwill or capitalization of brand advertising and other similar adjustments are the translations that occur to Economic Profit to make it EVA.

Accountancy Definition of “Residual Income”:

(Net Income)-((assets)x(preferred rate of return on assets))

Explanation:

Find out the worth of everything a company has (assets) and multiply that by the decimal equivalent of the minimum percent of return on invested assets (ROI) that is preferred. Subtract that from the profit (Net Income) that the company makes and now you have the Residual Income. This is a way of measuring the performance of different companies when investing or helping management evaluate the performance of divisions within a company.

Example:

Company A has $2000 in Sales, $500 in Expenses, and $5000 in Assets. You just decide that 15% is a good amount for the Return on Investment. Sales minus Expenses gives Company A $1500 in Profit. Assets times the minimum ROI gives you $750 as the minimum preferred profit. This minus the actual profit gives you $750 in Residual Income. $1500 - ($5000 x (15%=0.15)) = $750

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By Andrew O on Apr 14, 2009