One of the best ways to learn about finance is to start with a real story that everyone can relate to – a story that even children can understand. The most iconic – if not the most enjoyable – childhood business venture is the lemonade stand. Setting out a table and serving a few drinks to the neighbors on a hot summer vacation afternoon may seem like a simple, spontaneous endeavor, but it can also illustrate many basic financial concepts.
So you wake up one summer morning and after getting over the initial joy of the first few weeks without school, you’re bored and decide to do something productive with your free time. They decide to open a lemonade stand.
You make a quick inventory of the supplies you need to get started – mugs, soda mix, a pitcher, a cooler, a sign – and realize you need to head to the store to get more mugs and mix them. You run upstairs to get some cash from your piggy bank and discover you only have a dollar. You know you need at least five dollars to buy supplies.
Which brings us to our first finance lesson. We need capital or money now, but we won’t have any money until we sell some lemonade. Fortunately, finance is destined to solve just such a problem. Finance enables people to access capital when they need it.
Borrowers can get money now when they need it most and repay it later when they have more access to money and their need is less severe. Savers can lend or invest their money now when they have money and need it less, and pay it back later when they need more money – perhaps in retirement.
So back to our lemonade stand, we need to borrow some money. As with any entrepreneur, the first place you look for money is friends and family – or in our case, Mom and Dad.
Friends and family are an attractive source of financing for entrepreneurs because they know the potential borrower better than a bank and therefore usually offer better loan terms such as a lower interest rate.
You explain your plans to Mom and that you think you need four more bucks to get your lemonade stand started. She agrees to show you the money and you rush to the store to buy your supplies. The total bill comes out to $4.50, which is great as it leaves you with 50 cents of working capital to use to switch customers.
Before the lemonade stand opens, let’s take a look at what’s going on from an accounting perspective. It’s important to get a rudimentary understanding of accounting so we can measure the company’s financial performance and understand how well we’re doing.
So let’s start with our balance sheet. The balance sheet is one of the annual financial statements of a company. It represents a snapshot of a company’s financial condition at a given point in time. It lists the value of the company’s assets followed by its liabilities. A balance sheet can be summarized with a simple equation:
Assets = liabilities + management 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 we only had a dollar in cash, so our balance sheet equation looked like this:
$1 Cash = $0 Liabilities + $1 Equity
But as soon as we got a loan from Mama, our balance sheet changed. Our cash has gone up by the $4 we got from Mom, and now our debt has gone up by $4 because we owe Mom the money.
$5 cash = $4 liabilities + $1 equity
Note that whenever a financial transaction takes place, both sides of the equation must be balanced – hence the name balance sheet.
After we buy supplies for our lemonade stand, our assets change, but the liabilities side of the balance sheet stays the same.
$4.50 in inventory + $0.50 cash ($5 total assets) = $4 liabilities + $1 equity
Although this is a very simple balance sheet, it clarifies the basic purpose of the balance sheet – the description of a company’s assets and the claims on those assets (liabilities).
Now let’s sell some lemonade!
You set up your booth at a great spot in your neighborhood and it turns out to be a great day for lemonade sales. You get the price spot on and in just a few hours you’ll have sold all of the lemonade you bought. You dismantle your stall and go back inside to count your earnings.
You ended up selling 50 cups of soda at 50 cents each, for a total of $25 in sales. So what did you earn in profit? It’s time to bring the accounting back out.
In order to determine the profit, we should create an income statement for the lemonade stand. Sometimes income statements are referred to as income statements or income statements. An income statement simply takes the difference between a company’s income and expenses to determine net income, or profit, over a specific 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 factor in labor costs (you should be paid for the time spent making and selling lemonade), but for now we’ll only be looking at utility costs. The income statement of the lemonade stands for the first day of operation would look like this:
$25 Income – $4.50 Expenses = $20.50 Net Income
What is our balance sheet now? We’re out of supplies, just a bunch of cash ($25.50 including the 50 cents of working capital we had for change). We started with $4 in liabilities and $1 in equity, but now we have $21 in total assets, so our liabilities are no longer balanced.
All profit from our lemonade stand accrues to the owner and is therefore credited to the owner’s equity account. So our new balance sheet looks like this:
$25.50 cash = $4 liabilities + $21.50 equity
You look at your balance sheet to take stock. You started with just a dollar of equity and now you have over 20. Not too bad. You look at your income statement and see that your net income was $20.50, which is exactly the increase in your equity.
When you’re happy with your venture, you go back to Mom and pay back the four dollars you loaned 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 is:
$21.50 cash = $0 debt + $21.50 equity
Day one in the soda business taught us a few basic finance and accounting concepts, but why stop there? Maybe we should take our lemonade business to the next level. Stay tuned.