In short
Residual income is an investment center's operating income minus a required return on its invested capital (the minimum rate of return × invested capital). It measures the income earned above the cost of the capital used.
Key takeaways
- Unlike return on investment, it encourages managers to accept any project earning more than the minimum rate.
- Economic value added is a variant using after-tax operating income and the weighted-average cost of capital.
- Because it is an absolute amount, larger divisions tend to show larger residual income.
Example
Operating income $200,000, invested capital $1,000,000, minimum return 12%: residual income is $200,000 − $120,000 = $80,000.
Where it's tested
BAR: Financial Statement Analysis — study notes, a five-minute revision sheet and practice questions.
Practise: 3 questions
Question 1 of 3 · 0 answered
A company with a current ratio of 0.8 uses cash to pay off an accounts payable balance. What is the effect on the current ratio?