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 children can understand. The most iconic, if not the most fun, business enterprise of childhood is the lemonade stand. Setting a table and serving a few drinks to the neighbors on a hot afternoon during the summer holidays may seem like a simple and spontaneous undertaking, but it can also illustrate many fundamental concepts of finance.
So you wake up one summer morning and, after getting over the initial joy of the first few weeks without school, you are bored and decide to do something productive with your free time. You decide to set up a lemonade stand.
She takes a quick inventory of the supplies she will need to get started (cups, lemonade mix, a pitcher, a cooler, a sign) and realizes that she will have to go to the store to pick up more cups and mix. You run upstairs to get some cash out of your piggy bank and discover that you only have one dollar. You know you will need at least five dollars to buy supplies.
This brings us to our first finance lesson. We need capital or money right now, but we won’t have money until we’ve sold lemonade. Fortunately, finance is meant to solve that problem. Finance allows people to access capital when they need it.
Borrowers can get money now when they need it most and pay it back later, when they have more access to the money and their need is not so great. Savers can lend or invest their money now, when they have money and don’t need it as much, and then get repaid when they need more money, perhaps in retirement.
So going back to our lemonade stand, we have to borrow some money. Like any entrepreneur, the first place you look to borrow money is your friends and family, or in our case, mom and dad.
Friends and family are an attractive source of financing for entrepreneurs because they are more familiar with the potential borrower than a bank and therefore tend to offer better loan terms, such as a lower interest rate.
He explains his plans to Mom and thinks he will need another four dollars to start his lemonade stand. She agrees to advance the money and you rush to the store to buy your supplies. The total bill comes in at $ 4.50, which is great because you have 50 cents of working capital left that you can use to make changes for clients.
Before the lemonade stand opens, let’s take a look at what’s been going on from an accounting perspective. It is important to gain a rudimentary understanding of accounting so that we can measure the financial performance of the business and understand how well we are doing.
So let’s start with our balance sheet. The balance sheet is one of the financial statements of a company. Represents a snapshot of the financial situation of a company at a given time. List the value of the company’s assets followed by its liabilities. A balance sheet can be summarized by a simple equation:
Assets = Liabilities + Owner’s 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 started, all we had was a dollar in cash, therefore our balance equation looked like this:
$ 1 Cash = $ 0 Liabilities + $ 1 Owner’s Equity
However, as soon as we got a loan from Mom, our balance sheet changed. Our cash increased by the four dollars we received from Mom and now our obligations have also increased by four dollars because we owe the money to Mom.
$ 5 Cash = $ 4 Liabilities + $ 1 Owner’s Equity
Keep in mind that whenever a financial transaction occurs, both sides of the equation must still balance, hence the name balance.
After we purchase supplies for our lemonade stand, our assets change shape, but the liability side of the balance sheet remains the same.
$ 4.50 in supplies + $ 0.50 in 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: to describe a company’s assets and the claims on those assets (liabilities).
Now let’s sell lemonade!
You set up your booth in a great location in your neighborhood and it turns out to be a great day for a lemonade sale. You set the right price and after just a couple of hours, you have sold all the lemonade you had bought. You lower your stall and return home to count your winnings.
He ended up selling 50 cups of lemonade for 50 cents a piece for a total of $ 25 in revenue. So what did you gain in terms of earnings? It’s time to get back to accounting.
To determine the earnings, we must put together an income statement for the lemonade stand. The income statements are sometimes called profit and loss or profit and loss statements. An income statement simply takes the difference between a company’s income and its expenses to determine net income or profit over a certain period of time.
Income – Expenses = Net Income
In our case, we have $ 25 in income and $ 4.50 in expenses. One could argue that we should price on labor costs (you should be paid for the time you spent making and selling lemonade), but for now, we’ll only look at supply costs. The income statement for the lemonade stand for its first day of operation would look like this:
Income of $ 25 – Expenses of $ 4.50 = Net Income of $ 20.50
So what does our balance sheet look like now? We no longer have supplies, just lots of cash ($ 25.50 including the 50 cents of working capital we had for the change). We started 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 profits from our lemonade stand increased for the owner, therefore it is added to the owner’s equity account. So our new balance looks like this:
$ 25.50 Cash = $ 4 Liabilities + $ 21.50 Owner’s Equity
Take a look at your balance sheet to take inventory of how you did. He started with just a dollar in capital and now he’s 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 his business, he goes back to Mom and pays her the four dollars she borrowed from him. Since she kept the money for less than a day, she says she doesn’t owe you any interest. At the end of the day, your balance sheet says:
$ 21.50 Cash = $ 0 Liabilities + $ 21.50 Owner’s Equity
The first day in the lemonade business has taught us some basic accounting and finance concepts, but why stop there? Maybe we should take our lemonade business to the next level. Stay tuned.