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 enjoyable, business venture from childhood is the lemonade stand. Setting a table and serving drinks to the neighbors on a hot afternoon during summer vacation may seem like a simple and spontaneous adventure, but it can also illustrate many fundamental financial concepts.
So you wake up one summer morning and after 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.
You take a quick inventory of the supplies you’ll need to get started (glasses, lemonade mix, a pitcher, a cooler, a sign) and realize you’ll need to head to the store to pick up more glasses and mix. You run up the stairs to get some money out of your piggy bank and find 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 have a need for capital, or money, right now, but we won’t have money until after we’ve sold some lemonade. Fortunately, finances are meant to solve that problem. Finance allows 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 is not 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 get paid back later when they need more money, perhaps in retirement.
Going back to our lemonade stand, we need to borrow some money. Like any entrepreneur, the first place you look to borrow 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 are more familiar with the potential borrower than a bank is and will therefore generally offer better loan terms, such as a lower interest rate.
You explain your plans to Mom and you think you’ll need another four bucks to start your lemonade stand. She agrees to give you the money in advance and you run to the store to buy your supplies. The total bill comes to $4.50, which is great because you have 50 cents left over in working capital that you can use to give customers change.
Before the lemonade stand opens its doors, 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 company 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. It represents a snapshot of a company’s financial position 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 works, let’s take a look at the steps our balance has taken so far. When we started, all we had was a dollar in cash, so our balance sheet equation looked like this:
$1 cash = $0 liabilities + $1 owner’s equity
However, as soon as we received a loan from mom, our balance sheet changed. Our cash went up by the four dollars we got from mom, and now our liabilities also went up by four dollars because we owe mom the money.
$5 Cash = $4 Liabilities + $1 Owner’s Equity
Keep in mind that any time 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 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 rights to those assets (liabilities).
Now let’s sell some lemonade!
You set up your booth in a great location in your neighborhood and it turns out to be a great day for lemonade sales. You set the price right, and after just a couple of hours, you’ve sold all the lemonade you’ve bought. You remove your stall and return home to count your winnings.
You ended up selling 50 cups of lemonade for 50 cents a piece for a total of $25 in revenue. So what did he win in terms of earnings? It’s time to get the bookkeeping out again.
To determine profit, we must put together an income statement for the lemonade stand. Income statements are sometimes called profit and loss or P&L statements. An income statement simply takes the difference between a company’s income and expenses to determine net income or profit over a certain period of time.
Income – Expenses = Net Income
In our case, we have $25 of income and $4.50 of expenses. One could argue that we should price labor costs (you should be paid for the time you spent making and selling lemonade), but for now, we’ll just look at supply costs. The income statement for the lemonade stands for your first day of operations would look like this:
$25 Income – $4.50 Expenses = $20.50 Net Income
So what does our balance sheet look like now? We no longer have supplies, just a lot 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 shareholders’ equity, but now we have $21 in total assets, so our liabilities no longer balance.
All profits from our lemonade stand accrue to 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
You take a look at your balance sheet to take inventory of how you did. You started with just a dollar in stock and now you have over 20. Not 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.
Satisfied with his business, he returns to Mom and pays her the four dollars he borrowed from her. Since he kept the money for less than a day, she says she doesn’t owe him any interest. At the end of the day, her balance says:
$21.50 cash = $0 liabilities + $21.50 owner’s equity
Day one in the lemonade business has taught us some basic finance and accounting concepts, but why stop there? Maybe we should take our lemonade business to the next level. Stay tuned.