Banking 2: A bank's income statement

Let's go over that example, that I gave in the last video, where I'm in this village and I start a bank to match up savers with investment opportunities. And I actually want to do it, one, to hit the point home a little bit more about how a bank makes money. And I actually think this example is a very good instrument to teach you about a new financial statement that I don't think I've covered at all much. And that's the income statement. So far, you're familiar with the balance sheets, hopefully. And now, we'll learn what an income statement is. So let's say that this is my balance sheet at the beginning of my first year of operation, the beginning of year one. And let me see if I can recreate it. I think I had said that I had originally capitalized this company with $1 million. That was coming from my savings. Or maybe I went to 10 of my friends and they gave me $100,000 each. But we don't care about how that equity was raised. All we know is that we had $1 million. And then, I had bought a building that I could put money in, that looks really safe. And people would feel secure giving that money, putting that money into that building. So let's say I had $1 million of real estate. And then, the rest of the village saw this nice big fortress I had constructed. And so they gave me at least part of their savings as deposits. Saying that, wow, that's a safer place to put my money than in my mattress or buried in my backyard. And, this bank of Sal says that he's going to give me some interest. And he seems to be a fairly reputable fellow in our village. So let's deposit some of our savings with him. So I get $10 million of deposits. And, of course, I told them, look, this isn't a loan. Although, it kind of is. I'm not borrowing this money from you. You guys can use this money whenever you need it. And because of that, I need to set some of these deposits aside, in case someone comes the next day and says, I gave you that dollar yesterday. I actually need that dollar now to pay for my teeth cleaning or something. So I need to set aside some of it. And I figure, well, if I set aside 10% of it, that's the most that anyone would ever come in one day, unless there's some type of strange run on the bank. So I'm going to set aside 10% of it as reserves. So it's cash reserves. So let's say, $1 million of cash. If I thought, for some reason, that there's a higher likelihood of everyone coming at once for their money, or a large percentage of the people coming at once, I'd want larger reserves. And then, finally, I'm left with $9 million. They gave me 10, I had to put one aside. I'm left with $9 million to loan out. This is productive capital. And when I say, capital, that's just a claim on someone's goods and services that can be used to construct or perform something that adds value, that creates more value than was used. So that's $9 million of loans. And I know I always keep talking in those terms. And I do that because I think, in our society today, we get so fixated with the points, and that's money, or the dollar bills, that we often forget what the points represent. The points, or the money, represents claims on goods and services. I've actually met people who become obsessed with-- Well actually, like on [? Connicet, ?] I get emails from people who want to get extra points on their account. And they're obsessed with it. And it's just a number. But what's important is, what does a point system really do for you? And in money, those points represent future claims on goods and services. So this is how my balance sheet looked at the beginning of year one. And I said, well, I'm going to be getting in 10% on these loans. And let's say that I'm very good and none of them default. And I really do get my 10%. And I said that I'm going to pay these people out 5%. So what happens over the course of that year? So how much interest income am I going to get? I'll call that interest, Int Inc. So 9 million times 10%. I'm going to get $900,000. And then, what's my interest expense? I probably should have done this in green. Well, I have to pay out 5% on the $10 million. So it's $500,000. I'll put it as a negative number, just so you know it's an expense. Although, since I said it's an expense, you might want to put it as a positive number. But that's just an accounting convention. But I think you get the idea. Let me put it as minus $500,000. And then to operate this bank-- I had this building. it had to be cleaned. It has to be maintained. I had to hire bank tellers and security guards. And I had to buy my security guards machine guns. I have expenses, above and beyond just this little interest transaction that's going on. So let's say that I have salaries. So I have some other expenses. Let's say it's minus 50K a year in salaries that I have to pay. And let's say, upkeep of the building-- you have to paint it every now and then. Have to install new marble tiles every now and then. Because I have to project this impression of the shining, impenetrable fortress. So upkeep is actually a big expense for me. So I spend 50K on upkeep. And so, what am I left with? Let's see, 900 minus 500 is 400, minus another 100. So I'm left with 300,000. But even though this is a primitive village that I live in, it's not so primitive that it does not have taxes. And so, this is my pre-tax income. [PHONE RINGS] My cellphone is ringing, but I'll ignore it. Actually, it's very hard to ignore. But anyway, this is my pre-tax income. But my local village government says, well, you have to pay for the army and all of the other services that we provide. So they take 30%. So income taxes. Let's say they take one third. So they take 100K. And so, what am I going to be left with? What is my net income? 300 minus 100, I'm left with 200K. Fair enough. And, just so you know, this is the income statement. And I'm going to talk a little bit about how all of these match up. So let me let me draw big, nice box around it. So it looks like a proper statement of something. So what is my balance sheet going to look like at the end of the year, given that this is how much money I made? Well, let's say those loans haven't been paid off, just people paid the 10% interest on them. So I still have those loans on my balance sheet. Let me draw the loans. So I still have $9 million of assets, which are those loans. They haven't paid them off. I still have the building. And actually since I spent 50,000 on upkeep, all of the wear and tear was made up for, with my upkeep. So it's still worth a million dollars. So I still have a million dollar building, 9 million of loans outstanding. I had a million dollars of cash. And now, how much cash do I have? Well, I had that million dollars before. And I'm assuming that my overall level of deposits do not change over the course of the year. So I had a million dollars of cash, and nothing dramatic happens with the deposits. Over the course of the year, I show right here, I made $200,000. And this 200,000 is, essentially, going to be cash now. So now, I have 1.2 million of cash. My deposits haven't changed. I still have 10 million of deposits. Those are liabilities, because I owe them to the people who've deposited their money with me. I owe them money. And so what am I left with? What is my equity? My equity was 1 million. What is my equity now? Well, equity is just total assets minus total liability. So what are my total assets now? 9 plus 1 is 10, plus 1.2. I have 11.2 million of total assets. Minus my total liabilities, minus 10. So I have 1.2 million, now, of equity. Now, something interesting has happened. What has been my change in equity? I had $1 million of equity. Now I have $1.2 million of equity. So my change in equity-- so $1 million to $1.2 million. So we could call it, if you're used to the math notation, you could use that delta notation. Triangle just means change. My change in equity is equal to $200,000. And that is the same thing as your net income. So what is an income statement? Well, first of all, this is an income statement. But how does it connect with the balance sheet? And later, we'll talk about the cash flow statement. Well, a balance sheet is just a snapshot of what you have and what you owe at any given point in time. This is the balance sheet at the beginning of the year. This is the balance sheet at the end of the year. This is a snapshot of what you have and what you owe at the beginning. This is a snapshot of what you have and what you owe at the end of the year. The income statement tells you what happened over the course of this year. So it essentially tells you how did you get from this balance sheet to this balance sheet. Another way to think about it, the income statement, at the end, it'll tell you all of your inputs. What money came in. What money came out in the form of expenses and taxes, et cetera. And then, you get a net income number. And that net income number is actually the change in equity. So if you have a positive net income in a year, the balance sheet's equity will increase by that amount in a year. And if you have a negative net income, your balance sheet's equity will decrease in a year. So you could actually call your net income is the same thing as your change in equity. And, another thing you want to talk about, what's your return on equity? Well, your initial equity was $1 million. How much money did we make? Well, it grew by $200,000. So 200,000 over 1 million. Well, we could call that 1,000 thousands. That equals a 20%. That was our return on equity. We put in a million, and we got 20% more than that. That was our return on equity. Equals ROE. And notice, the return on equity is really-- that's the same thing. That's change of equity divided by starting equity, which is the same thing as net income in the period. Well, I'm defining it as starting equity. Sometimes people talk about it as average equity, and all of that. Anyway, I thought that this was a good tool to at least introduce you to the notion of an income statement, and show you how to all connects. Because that's the beauty of accounting. It's that you have these different financial statements that are very intertwined with each other. You give me two balance sheets. And then, I can actually construct the income statement that must have happened in between them. Anyway, see you in the next video.