One of the best ways to learn about finances 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 the neighbors a few drinks on a hot afternoon during summer vacation may seem like a simple and spontaneous adventure, but it can also illustrate many fundamental concepts of finance.

So you wake up one summer morning and having overcome the initial joy of the first 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 have to head to the store to pick up more glasses and mix. You run upstairs to get some money out of your piggy bank and discover 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 any money until after we’ve sold some lemonade. Fortunately, finance is 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 later when they need more money, perhaps in retirement.

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 and will therefore generally offer better loan terms, such as a lower interest rate.

You explain your plans to Mom and think you’ll need another four dollars to start your lemonade stand. She agrees to give you the money up front 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 of working capital left 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. 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 point in 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 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 increased by the four dollars we received from Mom, and now our liabilities also increased by four dollars because we owe Mom the money.

$5 Cash = $4 Liabilities + $1 Owner’s 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.

After we buy supplies for our lemonade stand, our assets change shape, but the liability side of the balance sheet stays the same.

$4.50 Supplies + $0.50 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 stand 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 only a couple of hours, you have sold all the lemonade you bought. You remove your stall and return to the house to count your winnings.

You ended up selling 50 cups of lemonade at 50 cents a piece for a total of $25 in revenue. So what did he gain in terms of earnings? It’s time to do the accounting again.

To determine profit, we need to put together an income statement for the lemonade stand. Income statements are sometimes called profit and loss statements or P&L. An income statement simply takes the difference between a company’s revenues and expenses to determine net income or earnings over a certain period of time.

Income – Expenses = Net Income

In our case, we have $25 of income and $4.50 of expenses. It could be argued that we should put a price on 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 their 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 change). We started with $4 in liabilities and $1 in 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 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 stock of how you did. You started out with just a dollar worth of stock and now you have over 20. Not bad. 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 his undertaking, he returns to Mom and repays 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

The first day in the lemonade business has taught us some finance and accounting basics, but why stop there? Maybe we should take our lemonade business to the next level. Stay tuned.

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