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Using a home purchase to illustrate assets, liabilities and owner's equity. Created by Sal Khan.
Video transcript
Welcome. Well there's been a lot of news lately about what's going on with Bear Stearns and Carlisle Capital. And I go to these parties, and I start explaining to people because it's very exciting. It's actually very important, to all of our collective futures and the whole health of the financial system, and I feel like people's eyes start to glaze over. So with that in mind, I decided to take a little bit of a hiatus from the core math and physics videos, and actually do some accounting and finance videos. Because I think what's happening in the world right now is 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 the basic accounting. What is a write-down, what does it mean when you don't have liquidity, in really tangible ways. So I'm going to use the same Khan Academy techniques to hopefully explain some of this. 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 say a scenario. Let's say I want to buy a house. So this is, let me draw a house. So let's say this is the 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, let's say I have $250,000. So what I'm going to do is, I'm going to create my balance sheet before I do anything. Before I go to 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. You can, 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 on vacation. So there's all sorts of things you can do. I don't know if someone dancing for you is an actual 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, I have $250,000 worth of cash. What are my liabilities? I'm going to write the liabilities on the left-hand side. I think that's the convention, but I forget. It doesn't matter. What are my liabilities? Well, a liability is something that's an economic obligation to someone else. So if I take a loan from someone, I owe them interest, or I have to pay them back the actual value of the loan one day. Say I have an IOU where I promise to dance for someone in the future. That could be a liability. It'd be hard to value, but that's something that I have to do in the future. But what are my liabilities here? Well in the example I gave, I'm just Sal, I have no debt, I paid off my college loans, 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, that to me is the definition of freedom. So I have zero liability. So what is my equity? And you've 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. So in this case, our assets are $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. So in this case, if I made a balance sheet before I enter into 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. That's a neat square. You probably can't see that square. So I put my assets on the right-hand side. And I'll say, there, I have $250,000 of cash. And on the left-hand side, I have no liabilities. And I'll just say I have equity, I have $250,000. Now, equity might not make a lot of sense to you right now, because I'm just saying, well, my equity is equal to my cash. in general, equity is just what you own. 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 pay off all of my debts, what do I have left over? Well I have no debts, so I have $250,000 in cash, total. 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 a $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 won't go into all the silly things that they do, but they do many silly things. We'll go into that 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. So they're going to hold this little security that says, Sal owes me $750,000. And he has to give me 10% interest every year. So $75,000 a year, or something like that. And in return I get $750,000 in cash. So what does my balance sheet look like now? Well, let me draw it. Let me make sure my balance sheet now looks, let me draw it like a square, because I think the visual representation is helpful, and then I will split it. So what are all my assets now? I had $250,000 and I got another $750,000 from the bank. So now, what are my assets? Well, $250,000 plus $750,000. 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 liabilities, I'll just say L, L for liabilities, because I'm running out of space. My wife was 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 would look at this formula. Assets equal liabilities plus equity. This is $1 million, this is $750,000. What do I have left over? Well, I have $250,000 left over. That's my equity. And I think hopefully the concept of equity is starting to make a little more sense. Now we have-- I could say that I have $1 million, and some people are like that. They think they're millionaires when they have $1 million in assets. But they don't consider, well they might have $1 million of assets, but they might owe other people $900,000. So I wouldn't consider that person a millionaire. They're more of a hundred thousand-aire. Your 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 can have claim to. And that's your equity. Sometimes it's called owners' equity. Or if there was a bunch of people pitching together, it would be called shareholders' 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 is starting to seem a little bit useful. 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 old owner of the house. Or maybe this Toll Brothers, they just built this McMansion for me. So I give them $1 million, and in return they give me the deed to the house. I could just say they give me the house. The house is always there, but you know it's really just a contract and all the legal structure that I get around it, and all the property rights and all of that. But that's getting too philosophical. So now what does my balance sheet look like? Instead of cash-- 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 overpay, whatever. I now have, my assets are a $1 million house. And I owe the bank $750,000. So what's 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 a little bit more about what's going on in the world. See you soon.