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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 children can understand. The most iconic—if not the most enjoyable—business venture of childhood is the lemonade stand. Setting up a table and serving a few drinks to your neighbors on a hot afternoon during summer vacation may seem like a simple, spontaneous endeavor, but it can also illustrate many fundamental concepts of finance.
So you wake up one summer morning and after you’ve 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 quickly take inventory of the supplies you’ll need to get started—cups, lemonade mix, pitcher, cooler, sign—and realize you’ll need to head to the store to pick up more cups and mix. You run upstairs to grab some money from your piggy bank and realize you only have a dollar. You know you will need at least five dollars to buy supplies.
This brings us to our first financial lesson. Right now we need capital or money, but we won’t have it until we sell some lemonade. Fortunately, finance is designed to solve just such a problem. Finance gives people access to 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 money and their needs are not as great. Savers can lend or invest their money now, when they have it and don’t need it as much, and then get paid back later when they need more money—perhaps in retirement.
So if we go back to our lemonade stand, we need to borrow some money. As with any entrepreneur, the first place you borrow money from 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 would be and will therefore usually offer better loan terms, such as a lower interest rate.
You explain your plans to Mom and that you think you’ll need four more dollars to start your lemonade. She agrees to pay you the money and you rush to the store to buy your supplies. The total bill is $4.50, which is great because it leaves you with 50 cents of working capital to use for change for customers.
Before the lemonade stand opens, let’s take a look at what’s going on from an accounting perspective. It is important to gain a basic understanding of accounting so that we can measure a company’s financial performance and understand how well we are doing.
So let’s start with our balance sheet. The balance sheet is one of the company’s financial statements. It represents a snapshot of the company’s financial position at a given moment. It states the value of the company’s assets, followed by its liabilities. The balance sheet can be summarized by a simple equation:
Assets = Liabilities + Equity
To better understand how a balance sheet works, let’s review the steps 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 equity
As soon as we got the loan from my mother, however, our balance changed. Our cash has increased by the four dollars we received from mom, and now our liabilities have also increased by four dollars because we owe mom money.
$5 cash = $4 liabilities + $1 equity
Keep in mind that every time a financial transaction occurs, both sides of the equation still have to balance—hence the name balance sheet.
When 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 inventory + $0.50 cash ($5 total assets) = $4 liabilities + $1 equity
Although this is a very simple balance sheet, it illustrates the basic purpose of the balance sheet – a description of the company’s assets and the claims against those assets (liabilities).
Now let’s sell some lemonade!
You set up your stand in a great location in your neighborhood and it turns out to be a great day to sell lemonade. You set the price just right and after a few hours you sold all the lemonade you bought. You remove the rack and return to the house to count your earnings.
You ended up selling 50 cups of lemonade at 50 cents each for a total of $25 in revenue. So what did you earn in terms of profit? Time to get the accounting out again.
To determine the profit, you should prepare an income statement for the lemonade stand. Income statements are sometimes called income statements or profit and loss statements. The income statement simply takes into account the difference between a company’s revenue and its expenses to determine the net income or profit over a period of time.
Revenue – Expenses = Net Profit
In our example, we have $25 in revenue and $4.50 in expenses. You could argue that you should value labor costs (you should be paid for the time you spent making and selling lemonade), but for now we’ll just look at delivery costs. The Lemonade stand’s income statement for the first day of business would look like this:
$25 in revenue – $4.50 in expenses = $20.50 in net income
So what is our balance sheet now? We no longer have any inventory, just a lot 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 profits from our lemonade stand belong to the owner, so it is added to the equity account. Our new balance sheet looks like this:
$25.50 cash = $4 liabilities + $21.50 equity
Take a look at your balance sheet to take stock of how you’ve been doing. You started with just one dollar of capital 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 the exact increase in your owner’s equity.
Satisfied with your company, you return to your mother and return 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 equity
Our first day in the lemonade business taught us some basic financial and accounting concepts, but why stop there? Maybe we should take our lemonade business to the next level. Stay connected.
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