The Lemonade Stand
One of the best ways to learn about finance is to start with a real-world story that everyone can relate to - a story that even kids can understand. The most iconic - if not most enjoyable - business enterprises of childhood is the lemonade stand. Setting up a table and serving a few drinks to neighbors on a hot afternoon over summer vacation may seem like a simple, spontaneous venture, but it can also illustrate many fundamental concepts of finance..
So you wake up one Summer morning and having gotten over the initial joy of the first few weeks with no school, you're bored and decide to do something productive with your free time. You decide to start a lemonade stand.
You take a quick inventory of the supplies you'll need to get started - cups, lemonade mix, a pitcher a cooler, a sign - and you realize that you'll need to head to the store to pick up more cups and mix. You run upstairs to grab some cash from your piggy bank and discover that you only have a dollar. You know you'll need at least five dollars to purchase supplies.
This brings us to our first finance lesson. We have a need for capital, or money, right now, but won't have any money until after we've sold some lemonade. Fortunately, finance is intended for solving just such a problem. Finance enables people to access capital when they need it.
For borrowers, they can get money now when they need it most and pay it back later when they have more access to money and their need isn't as great. For savers, they can lend or invest their money now when they have money and don't need it as much and then be repaid later when they need more money - perhaps in retirement.
So coming back to our lemonade stand, we need to borrow some money. Like any entrepreneur, the first place you look to borrower money is friends and family - or in our case, mom and dad.
Friends and family are an attractive source of funding for entrepreneurs because they are more familiar with the potential borrower than a bank would be and therefore will usually offer better borrowing terms like a lower interest rate.
You explain your plans to Mom and that you think you'll need another four dollars to get started with your lemonade stand. She agrees to front you the money, and you rush off to the store to buy your supplies. The total bill comes to $4.50, which is great because you're left with 50 cents of working capital that you can use to make change for customers.
Before the lemonade stand opens for business, let's take a look at what's been happening from an accounting perspective. It's important to get a rudimentary understanding of accounting so that we can measure the financial performance of the enterprise and understand how well we're doing.
So let's start with our balance sheet. The balance sheet is one of a company's financial statements. It represents a snapshot of a company's financial position at a particular point in time. It lists the value of the company's assets followed by its liabilities. A balance sheet can be summed up by a simple equation:
Assets = Liabilities + Owners' Equity
To better understand how a balance sheet works, let's look at the steps our balance sheet has gone through so far. When we first started, all we had was one dollar in cash, therefore, our balance sheet equation looked like this:
$1 cash = $0 Liabilities + $1 Owner's Equity
As soon as we got a loan from Mom, though, our balance sheet changed. Our cash went up by the four dollars we received from Mom and now our liabilities have also gone up by four dollars because we owe Mom the money.
$5 cash = $4 Liabilities + $1 Owner's Equity
Notice that whenever a financial transaction occurs, both sides of the equation still have to balance - hence the name balance sheet.
After we purchase supplies for our lemonade stand, our assets change form, but the liabilities side of the balance sheet remains the same.
$4.50 in supplies + $0.50 cash ($5 total assets) = $4 Liabilities + $1 Owner's Equity
Although this is a very simple balance sheet, it illustrates the fundamental purpose of the balance sheet - describing a company's assets and the claims on those assets (liabilities).
Now let's sell some lemonade!
You set up your stand at a great location in your neighborhood, and it turns out to be a great day for lemonade sales. You set the price just right and after only a couple hours, you've sold all the lemonade that you'd purchased. You take down your stand and head back into the house to count your earnings.
You wound up selling 50 cups of lemonade at 50 cents a piece for a grand total of $25 in revenue. So what did you earn in terms of profit? It's time to pull out the accounting again.
To determine profit, we should put together an income statement for the lemonade stand. Sometimes income statements are referred to as profit and loss statements or P&Ls. An income statement simply takes the difference between a company's revenues and its expenses to determine net income or profit over a certain period of time.
Revenues - Expenses = Net Income
In our case, we have $25 in revenue and $4.50 in expenses. One could argue that we should price in labor costs (you should be paid for the time you spent making and selling lemonade), but for now, we'll just look at supply expenses. The lemonade stands income statement for its first day of operations would look like this:
$25 Revenue - $4.50 Expenses = $20.50 Net Income
So what does our balance sheet now look like? We no longer have any supplies, just a lot of cash ($25.50 including the 50 cents of working capital we had for change). We started out with $4 in liabilities and $1 in owner's equity, but now we have $21 in total assets, so our liabilities no longer balance.
All the profit from our lemonade stand accrues to the owner, therefore, it gets added to the owner's equity account. So our new balance sheet looks like this:
$25.50 cash = $4 Liabilities + $21.50 Owner's Equity
You take a look at your balance sheet to take inventory of how you did. You started out with just a dollar in equity and now you have over 20. Not too bad. You take a look at your income statement and see that your net income was $20.50, which is the exact increase in your owner's equity.
Feeling satisfied with your enterprise, you go back to Mom and repay the four dollars you borrowed from her. Since you kept the money for less than a day, she says you don't owe her any interest. At the end of the day, your balance sheet reads:
$21.50 cash = $0 Liabilities + $21.50 Owner's Equity