Principles of Finance: Unit 3, The Logic of Balancing a Sheet

How does a balance sheet work, and how do you get it to...balance? We'll cover assets, liabilities, depreciation, liquidity, and all the good stuff in-between.

CoursesFinance Concepts
Principles of Finance
FinanceFinancial Responsibility
Personal Finance
Finance and EconomicsPrinciples of Finance
LanguageEnglish Language
Life SkillsPersonal Finance
SubjectsFinance and Economics

Transcript

00:23

for lemonade stands are us three days before the Super Bowl kickoff.

00:27

alright skim through the numbers skimming skimming. let's take a little

00:30

tour down balance sheet Lane and figure out how we actually apply these terms or

00:35

concepts. well the first lines actually begin to tell the story of our little

00:39

company. it was capitalized with a loan from grandmama that was originally

00:43

granted as a one-year loan. today it's something less than a year, because it's

00:47

current ie the principle of five grand is owed within the next year. and we also

00:52

know that three grand of that five grand has been burned. we needed to build the

00:56

stand by stools and you know all that jazz. well keep reading and we find the

01:00

hundred grand peg, that's a lot of dough well the NFL promised to pay us a

01:03

hundred grand if we delivered one hundred thousand cups eliminate to the

01:06

game. but they're not paying us upfront so we have to front the cash for all the

01:11

supplies, and yeah that's risky. the NFL could fire us at the drop of a hat and

01:16

if they do we're bankrupt and then some. we'd never be able to pay back our Visa

01:19

credit card bill grandmama and the cups vendors by just selling lemonade's in [credit cards get paid in a bankruptcy]

01:23

front of our house at our stand. all right but if we do make this deal work

01:27

it quote makes us unquote will have massive profits and be able to open five

01:32

more lemonade stands. so we roll the dice as it were and pray a lot and hope for

01:37

ha thirst inducing weather yeah Pro global. warming screw the polar bears.

01:41

we really don't have any other assets at this point is we're skimming there's no

01:44

brand value for our lemonade at Inc country time or Minute Maid or

01:49

Grandmama's. it's just a name worth squat at this point. note that we have zero

01:53

dollars in long-term debt. if grandmama had given us debt due in three years

01:58

well then it would live in the long term line not the current one. and note that

02:03

our long-term assets are PP&E- plant property and equipment -and in this line

02:08

while the item is held as net not gross. usually. what does that mean?

02:13

net well we said we'd burned two grand since starting the company. yes we've had

02:17

sales and we've also had expenses but we've basically been running close to

02:22

break-even thus far. we spent twelve hundred bucks on stools and stand six

02:25

months ago, it's our gross value and we figure [balance sheet pictured]

02:28

they'll last three years, and then break because someone will sit on them or play

02:32

with them after hours and we're not watching the yellow dom.e so we think

02:35

that 1,200 bucks original cost will be worth zero in three years and that it

02:39

will decline in value arithmetically. in accordance with how most things like

02:43

furniture or depreciated in accounting land. so if it goes to zero in three

02:47

years than every six months while it will decline in value by 1/6

02:51

well 1/6 of 1,200 bucks is $200 so we took $200 off the value of the $1,200 we

02:57

started with, and now hold the value of our stools and signage as a grand on our

03:01

balance sheet. so how do we best disclose these moving parts on the balance sheet?

03:05

we show our work. we have a line for gross PP&E that'd be like 1,200 bucks in

03:09

this case, and then we have a line for depreciation of PPE like 200 bucks there,

03:14

and then like a line of net PP&E and that's like exactly our grand. all right

03:19

get it got it good. note that we could have accounted for this depreciation

03:23

value in other ways. we could have thought about it like will our signs and

03:27

stools are worth a hundred bucks today on eBay. if we ever went out of business

03:31

like if the NFL punted us tomorrow well the signs and stools would get

03:35

liquidated on eBay. and so we should carry them today at their liquid value.[boy smiles behind lemonade stand]

03:40

yeah not a stupid idea. sorry that was a bad voice. we won't do

03:43

that again. in reality that logic is actually closer to the religion of GAAP.

03:47

than not right you want to be the most conservative that you can. it's a

03:51

realistic however there was one mitigating factor. we're not dead yet.

03:55

that is at this moment anyway life is looking bright. the odds of the Super

03:59

Bowl happening are high. and if it goes through as planned we make Bank. so since

04:03

we are healthy ish we don't need to depreciate everything suddenly to just

04:08

being liquidation value like that hundred-dollar thing on eBay. should

04:11

things change however we'll want our finger on the red button to bring those

04:15

values down fast. hopefully we don't have to do that it's not pretty.

04:19

in the same vein note the little note on inventory that it's held at cost. well

04:23

we'll have hated dime a cup for the massive cups, but

04:27

if we had to turn around and sell them again on eBay or somewhere because all

04:30

sales from cups are us are final, then we're likely to get less than a dime for

04:35

them so shouldn't we hold the value of that inventory at less? no because we're

04:40

still a going concern doing just fine. thank you very much. and we're optimist

04:45

at heart and that's why we're entrepreneurs and not you know college

04:48

professors or government workers or something. so let's take a pause here and [professor teaches class]

04:52

add things up thus far in our little history. on the Left we have two grand in

04:56

our Bank of America account a hundred grand in accounts receivable. we've build

05:00

the NFL they've promised to pay the week after the Super Bowl.

05:03

if 15 grand in inventory $1,000 in equipment the EE of PP&E all of the left

05:08

side totals $118,000. okay Alex the right side for 500. all right well we have

05:14

$5,000 in short-term debt tick-tick-tick it's coming due soon and

05:19

grandmama will send the baseball bat boys if we don't pay. she's a tough old

05:24

bird. ten grand payable to cups R Us five

05:26

thousand dollars owed on our Visa card for buying sugar and lemons at Costco

05:30

and that's about it. so on the right side we have a total of 20 grand.

05:33

oh wait that's not balanced at all. isn't the right side supposed to equal the

05:37

left like it does in the contested political states like Ohio and Florida?

05:41

yes it is. well what's left is shareholders equity. well how do we get

05:46

there well we just subtract the liabilities from the assets and we get

05:49

118 thousand minus 20,000 equals 98 grams. that means our company's worth 98

05:54

grand? well yeah kind of sort of. least the shareholders equity is. there's one more

05:58

wrinkle we have to digest first. the equity of the company. see that was the

06:02

easy Segway there. if you watch the opening of the sauce company and you [equity explained]

06:06

don't have short-term memory issues well you'll recall that in order to

06:09

capitalize the company to form it financially the founders wrote a check

06:13

for a very small amount of money to buy common stock in their own company. in

06:17

this case and let's say that our lemonade stand business is capitalized

06:20

with 10 million shares at 100th of a cent each. why so many shares and why so

06:25

cheap per share well we're glad you asked. the high number of shares allows

06:28

us as a founder CEO financial manager to grant shares to employees who want to

06:32

come on board later and help us grow the company.

06:34

it also lets us not have to sell fractions of a share

06:38

we find other investors who want to put money into us. for example if we

06:42

capitalize the company with just 10 shares at $100 to start well then we'd

06:46

write a check for a thousand bucks to capitalize the company, but what happens

06:50

if we do really well and I don't know in a year an investor is willing to give us

06:54

a company valuation of a million bucks and they want to buy 5% of the company

06:58

for an investment of 50 grand? well we'd have to sell them half a share and yes

07:02

that would be a pain. and the tiny amount per share reflects a few things. here

07:05

first that we are not rich and don't have a ton of money to capitalize the

07:09

company properly with an injection of a hundred grand or more of our own money. [lemonade stand stocks as example]

07:14

we're tiny .and second that our common stock sits behind pretty much every

07:18

other class of stock that other investors would buy in our company. if

07:22

things go poorly and we have to sell while the bank's get paid first for

07:26

their lines of credit, like grandmama then the bondholders get paid yeah,

07:30

that's the grandma laughing, then the preferred stockholders like venture

07:33

capital people get paid, and then at the very end of the brown rainbow we get

07:37

paid our common which is likely a lot of nothing. so we don't want to have a ton

07:41

of financial exposure to common stock at this point via our hard-earned cash

07:44

savings. we'll own 100 percent of the common stock on day one anyway we're the

07:48

sole founder here. so with ten million shares at a hundredth of a cent each

07:52

we've written a check to the company for a grand.

07:54

note that the notations then under the shareholders equity lines our retained

07:59

earnings are ninety seven thousand dollars yeah it's a lot an enormous

08:03

value we've created in a short time. Thank You Super Bowl contract .if the

08:06

Super Bowl goes well and we actually get paid we're stylin. [stacks and stacks of cash]

08:10

all right when you see the word other. you should split your brain in half half

08:13

of it should just ignore the term and the other half should get all uptight

08:16

about it all. right here's to the uptightness.

08:18

note that other comes up a bunch in all flavors of statements. income cash flow

08:24

and balance sheets note here that other short-term assets could be things like

08:28

prepaid rent or prepaid insurance or prepaid power gas and electric bills.

08:33

dicey startup companies are often asked to pay for things well in advance

08:37

because war-weary landlords have too many scars from small companies sneaking

08:42

off into the night and not paying the rent they owed last month. right but

08:46

think about how prepaid rent could should be is

08:49

asset. and it could be long-term and short-term right you have three year

08:53

prepaid rent on a place for three grand a month 36 months. you are funded by

08:59

venture capitalists and at that time you were swimming in cash. the time you know

09:03

when you set the rent deal with landlord. in order to get into the best building

09:06

in town at a nice discount per month you had to pay all three years of rent in

09:11

advance. that's 36 months times 3 grand or 108 thousand bucks .well at the moment

09:15

you sign the lease and paid the dough you had a short-term or current asset 12

09:21

times 3 grand 36,000 that was current asset got it and a long term asset of 72 [equations]

09:26

grand. the remaining 24 months a year or more later at 3 grand a month. all right

09:30

as the first 24 months went by the value of long-term asset gradually declined to

09:34

zero, and then when there was one year left on the lease it was $36,000 as a

09:39

current asset. well funky things happen in big bull markets with regard to rent.

09:44

as well oftentimes if long-term rentals happen at the bottom of a bad market the

09:49

value of the real estate goes up a lot as time goes by and in theory companies

09:54

could quote flip unquote their leases to the market which was paying 3 grand a

09:59

month but currently would be happy taking over the lease for 5 grand a

10:02

month. in theory companies could mark to market a gain of their current assets in

10:07

the rent lease thing, but since they almost never intend to move out of their

10:11

offices during the time of their lease and moving costs are usually really high,

10:15

in a pane they just leave the numbers as they are but you should know about all

10:18

that stuff so you get all this information from shmoop for no extra

10:21

cost what a deal. all right liquidity is a hugely important concept to understand [man straightens tie]

10:25

and be able to apply as well it's such a big deal that balance sheets are

10:29

organized under its auspices. note how our balance sheet is laid out. cash comes

10:33

first then accounts receivable then inventory then other think prepaid rent

10:37

here then long-term assets like PP&E and lastly other long termers. did things

10:42

happen in this order by accident? no not on your life. they're organized by

10:47

liquidity and there are really two reasons for that

10:50

well first should the company have to be liquidated the easy to sell stuff is

10:54

almost always the most liquid stuff and second the values of the more liquid

10:59

stuff are way tighter. meaning it become eighty-three thousand two hundred thirty

11:03

one dollars in cash in the bank well that cash is worth eighty three

11:07

thousand two hundred thirty one dollars. very liquid very precise not a lot of

11:10

debate no worries about conflicts of interest in selling that cash or

11:13

transferring it or whatever .it's worth what it's worth. but what about a 14-year

11:17

old tractor smelting plant or a 22 year old newspaper printing plant. well they

11:23

both still function but like what are they worth on eBay? the company paid a

11:27

million dollars for the printing plant twenty two years ago is it still worth

11:31

the million? well prices have gone up a ton over that time with inflation

11:35

printing plants are rare maybe the parts are worth a lot. or is it just scrap [value chart pictured with inflation factored in]

11:39

metal worth 10 grand waiting to be hauled away at a price and then melted

11:42

down. hmm very wide range there. low liquidity

11:45

low precision. anyway if you think about it cash would be super easy to liquidate.

11:50

an account receivable would be like collecting from the NFL the dough they

11:53

already committed to paying assuming the company performed on delivering that

11:57

service the a hundred thousand drinks and in order to show it as a receivable,

12:01

the service would have had to have been performed and delivered then collecting

12:04

from the NFL, well at that point should be very liquid. yeah it may take 30 days

12:09

but it's a pretty clear and safe bet to happen the NFL pays its bills alright.

12:13

then we go to inventory hmmm. this is harder who's gonna buy a million cops

12:17

and 5,000 pounds of sugar or whatever amounts you have on your books when you

12:22

go bankrupt. well tough to sell so the numbers get vague here really fast in

12:26

the form of the value you are carrying that inventory at Book value or what you

12:30

paid for it versus what the market will actually pay for [book value defined]

12:34

I don't know used sugar. what would they pay you in cash to buy all that used

12:38

cups anyone? yeah we think. not alright the others follow similar suit a

12:42

four months tail on a lease ain't worth much on the market. it's the league of

12:46

the 22 year old newspaper printing press thing not at all liquid. big discounts

12:51

big write downs at bankruptcy time and maybe big bargains for whoever is in the

12:54

market to buy a slightly used newspaper printing press. all right let's go back

12:58

to our balance sheets. most recent iteration and now look at this newly

13:02

updated one as of this morning. well so what happened here people well duh the

13:06

Super Bowl happened. Green Bay won forty two two three on a mercy field goal for

13:10

the other team at the end the NFL paid the inventory was used Grandmama's loan

13:14

was fully paid off the liability of ten grand to the cups

13:17

vendor and 5k to the Visa card and everything else it all adjusted. now how

13:21

much cash is in the bank? well a whopping $82,000 the value being held for the

13:27

stools didn't change and still about a grand everything else evaporated. and

13:31

note that the shareholders equity here is 82 grand. that is more or less the

13:36

company's entire Book value but a company that just generated such [balance sheets compared]

13:40

enormous pre-tax profits in such a short time, has to be worth a lot more than

13:45

$82,000 right? the market value of the company is a reflection of what an

13:48

outside investor would pay for a given percentage ownership of the company. if

13:53

you were thinking about raising capital at this moment with such a great

13:56

business momentum going well it's probably not a bad time to raise that

14:00

capital. there's one key and very important liability missing the above

14:03

sheet. any guesses right rhymes with sh max ? yep tax well you just made 50 grand

14:08

and change in profits you think the g-man is gonna let you keep all that

14:13

money guff ah. not gonna happen so if you live in a blue state assume you'll pay

14:18

about 30 percent of that 50 grand in taxes and well you should plug a fifteen

14:22

thousand dollar current liability of taxes payable here so it's obvious

14:26

you're thinking about it. no matter what kind of nightmares it gives you. [fancy car crashes]