Introduction to Balance Sheets

Khan Academy Presents: Using a home purchase to illustrate assets, liabilities and owner's equity.

Welcome, well there's been a lot of news lately about what's going on with the Bear sterns and Carlisle Capital. And I go to this parties and I start explaining to people, because it’s very exciting and actually very important to all of our collective futures and the whole financial system. And I feel like people’s eyes starts to glaze over. So with that in mind I decided to take a little bit of hiatus from kind of décor math and physics videos and actually do some accounting and finance video. Because I think what's happening in the world right now is extremely, extremely important. And I'm not just going to go straight into what's going into Carlisle and Thornburg and all of these characters. Because I think the newspapers do that, but a lot of people don’t understand kind of the basic accounting. What is a write down? What is it mean when you don’t have liquidity? And really tangible ways. So I'm going to use kind of the same economy techniques to hopefully explain some of these. So I'm going to start with just a very basic accounting concept of the balance sheet. You might have a sense of what it is. So let's state a scenario, let's say I want to buy a house. Let me draw a house. So let's say this is a house I want to buy. And the owner of this house is asking for $1 million for this house. And I like the house and I think that’s a fair price, other houses in the neighborhood also went for $1 million, whatever. Maybe they went for more, so I think it’s actually a good deal. But all I have in my pocket is $250,000. So what I'm going to do is I'm going to create my balance sheet before I do anything, before I try to get the house. What is my before house balance sheet? What are my assets? I'm going to write down assets. Well before we know what my assets are, let me tell you what an asset is. An asset is something that’s going to give you some future economic benefit. So for example, cash is an asset. Why is cash an asset? Because in the future, you can use that cash to get stuff from people or make them do things or buy stuff. And in a month from now you can use your cash and you can make someone dance for you. Or you can buy a car. Or you can go in vacation. So there's all sorts of things you can do, I don’t know if someone dancing for you is a natural economic benefit. But you get the idea. So cash could be an asset. A house could be an asset, because the economic benefit you get in the future is you get to live in it and not freeze when it’s freezing outside. So that’s what an asset is. So what are my assets before I buy the house or get a loan or all of the things that are about to happen. Well, I have cash and I have $250,000 worth of cash. Now what are my liabilities? I'm going to write the liabilities on the left hand side. And I think that's the convention, but if forgot, but it doesn’t matter. What are my liabilities? Well, a liability, it’s an obligation to someone else. It’s kind of like an economic obligation to someone else. So if I take a loan from someone, I owe them interest, well I have to pay them back. The actual value of the loan one day. Say I have an IOU where I promised to dance for someone in the future. That could be a liability, it would be hard to value, but that’s something that I have to do in the future. But what are my liabilities here? Well the example I gave, I'm just Sal. I have no debt. I paid off my college loans and everything. And I have $250,000 in cash. So what are my liabilities before I buy the house? Well nothing. I don’t have any liabilities. I don’t owe anybody anything. And that’s actually the definition of freedom. So I have zero liabilities. So what is my equity? And you probably heard this word people borrowing their equity and all of these things. So I'm going to give you a little equation actually, just to take a little bit of a tangent. That assets, A for assets, is equal to liabilities plus equity. Right? So in this case our assets is $250,000. My liabilities are what? I owe nothing to nobody. I don’t know if that was correct. But anyway, I owe nothing to anyone, so my liabilities are zero. So my equity must be $250,000, right? My equity is also $250,000. So in this case, if I made a balance sheet before entering to any transactions, let me make it look a little bit like a balance sheet. My assets are $250,000. I have no liabilities. And then my equity would be $250,000. And if I were to draw this graphically, actually, I should probably draw it like this. I have no liabilities, so let me draw another little mini balance sheet here. Let me draw it as a neat square. You probably can't see that square. Let me switch colors. So I put my assets on the right hand side, and say I have 250k in cash. In the left hand side, I have no liabilities, let's just say I have equity of 250. Now equity might not make a lot of sense to you right now because I'm kind of just saying, well my equity is equal to cash. In general, equity is just what you own. What after all of your assets and liabilities are kind of resolved or they're cleared up, what do you have left over? That’s equity. So in this situation, after I paid off all of my debts, what do I have left over? Well I have no debt, so I have $250,000 in cash left over. This will start to make sense when I go to the bank now to get a loan to buy this house. So this house is $1 million house, right? So how much of a loan do I need? Well, I have 250,000 cash, so I’ll go to the bank for a loan for the remainder, for $750,000. So let me draw the bank, this is the bank. The big dollar sign is made out of granite to show you that it can never fail. It’s going to be there forever even if they do silly things like, well I don’t want to go into all the silly things that they do. But they do many silly things. Well go on it later. But the bank is going to give me another $750,000 in cash. And in return, I'm giving them essentially an IOU. And I'm going to pay interest, right? So they're going to hold this little security that says Sal owes me $750,000. And he has to give me 10 percent interest every year. So $75,000 a year, something like that. And in return I get $750,000 of cash. So what is my balance sheet look like now? Well let me draw it. My balance sheet now looks, let me draw it like a square. I think the visual representation is helpful. So then I will split it. So what are all my assets now? I had $250,000 and now I got another $750,000, right? I got another $750,000 from the bank. So now, what are my assets? Well 250 plus 750, I now have cash of $1 million. What are my liabilities? Well my liability, that’s something that I owe to someone else. I owe the bank $750,000. So liability, I’ll just say L for liabilities. Because I'm running out of space. My wife is complaining that I make these things very hard to read, but what can I do. Anyway, so my liabilities, I owe the bank $750,000. So that’s a liability. And then the equity is essentially, we look at this formula, right? Assets equal liability plus equity. This is 1 million, this is 750. What do I have left over? Well I have $250,000 left over. That’s my equity. And I think hopefully the concept of equities is starting to make a little more sense. Now I could say that I have $1 million and some people are like that. They think they're a millionaire when they have $1 million assets. But they don’t consider, while they might have $1 million assets but they might owe other people $900,000. So I wouldn’t consider that person a millionaire. They're more of a hundred thousandaire. But you're assets might be $1 million, but you're not nearly a millionaire because you still owe other people 750,000. What you have left over, that really is your net worth or what you have claim to. And that’s your equity. Sometimes it’s called owner’s equity. Or if there are a bunch of people pitching together, we call them share holder’s equity. And maybe I’ll do a little bit more on that in the future. But hopefully now you can see that the balance sheet starting to seem a little bit useful. But I have the cash and I took the loan from the bank, but now I still haven’t bought the house yet. So what am I going to do? Well I'm going to give my cash to the house, to the old owner of the house. So maybe this tall brother, they just built this Mickey mansion for me. So I give them $1 million, and in return, they give me the deed to the house. I can just say they gave me the house. The house is always there, but surely it’s just the contract and all the legal structures that I get around with and all property rights and all of that. But that gets too philosophical. So now, what is my balance sheet looks like? Instead of cash, and I think I'm running out of space and time to draw another balance sheet. I don’t have cash worth $1 million, I now have a house worth $1 million. Assuming that it really is worth it and that was the correct price, I didn’t over pay him, whatever. I now have my assets are $1 million house and I owe the bank $750,000. So what's the left over for me is $250,000 of equity. I'm about to run out of time, so I'm going to leave you from this video. In the next video, I'm going to start explaining what happens if the value of the house goes up or down. Or you need cash and all of these interesting things and we’ll start to learn to a little bit more about what's going on with the world. See you soon.