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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. One of the most iconic – if not the most enjoyable – business ventures of childhood is the lemonade stand. Setting a table on a hot summer afternoon and serving the neighbors some drinks may seem like a simple, innocuous venture, but it can also illustrate several fundamental concepts of finance.
So you wake up one summer morning and having gotten over the initial joy of the first few weeks without 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 list of the supplies you’ll need to get started — cups, lemonade mix, a pitcher, a cooler, a sign — and you realize you need to go to the store to pick up more cups and mix. Will be You run upstairs to get some cash from your piggy bank and find you only have a dollar. You know you’ll need at least five dollars to buy supplies.
This brings us to our first finance lesson. Right now we need capital or money, but we won’t have any money until we sell some lemonade. Fortunately, finance aims to solve 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 funds and their requirement is not as great. For savers, they can lend or invest their money now when they have the money and don’t need it as much, and can 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 and foremost you look to borrow money are 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 and will therefore usually offer better lending terms such as a lower interest rate.
You explain your plans to Mom and figure out you’ll need another four dollars to get started with your lemonade stand. She agrees to pay you the money up front, and you go to the store to buy your supplies. The total bill comes to $4.50, which is great because you have 50 cents of working capital left over that you can use to make change for customers.
Before the lemonade stand opens for business, let’s take a look at what’s happening from an accounting perspective. It is important to get an initial understanding of accounting so that we can measure the financial performance of the enterprise and understand how well we are doing.
So let’s start with our balance sheet. Balance sheet is one of the financial statements of the company. It represents a snapshot of the financial position of the company at a particular point in time. It lists the value of a company’s assets followed by the company’s liabilities. A balance sheet can be summed up by a simple equation:
Assets = Liabilities + Owner’s Equity
To better understand how a balance sheet works, let’s take a look at the stages our balance sheet has gone through so far. When we first started, we only had one dollar in cash, so our balance sheet equation looked like this:
$1 cash = $0 liabilities + $1 owner’s equity
But, as soon as we got the loan from mom, our balance sheet changed. The $4 we got from Mom increased our cash and now our liabilities have increased by $4 because we owe Mom money.
$5 cash = $4 liabilities + $1 owner’s equity
Note 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, the form of our assets changes, but the liabilities side of the balance sheet remains the same.
$4.50 in supplies + $0.50 cash ($5 net worth) = $4 liabilities + $1 owner’s equity
Although this is a very simple balance sheet, it reflects the basic purpose of the balance sheet – to describe the company’s assets and the claims on those assets (liabilities).
Now let’s sell some lemonade!
You set up your stand in a great spot in your neighborhood, and it turns out to be a good day for a lemonade sale. You set the perfect price and after only a few hours, all the lemonade you bought was sold out. You take your stand and head back home to count your earnings.
You sell 50 cups of lemonade at 50 cents a piece for $25 in revenue. So what did you make in terms of profit? It’s time to settle the score again.
To determine profit, we must put together an income statement for the lemonade stand. Income statements are sometimes referred to as profit and loss statements or P&Ls. An income statement simply takes the difference between a company’s revenue and its expenses to determine net income or profit in a given period.
revenue – expense = 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 spend making and selling the lemonade), but for now, we’ll just look at supply expenses. The Lemonade Stand income statement for its first day of operations would look like this:
$25 revenue – $4.50 expense = $20.50 net income
So what does our balance sheet look like now? We now have no supplies, only lots of cash ($25.50 which includes the 50 cents working capital we had for change). We started with $4 in liabilities and $1 in owner’s equity, but now we have $21 in total assets, so we no longer have a balance in liabilities.
All profit from our lemonade stand goes 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
Take a look at your balance sheet to take stock of how you did. You started with just one 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 venture, you go back to your mother and repay the four dollars you borrowed from her. Since you kept the money for less than a day, she says you don’t have to pay any interest on it. At the end of the day, your balance sheet reads:
$21.50 cash = $0 liabilities + $21.50 owner’s equity
Our first day 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.
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