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Current time:0:00Total duration:11:59

Video transcript

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 to kind of match up savers with investment opportunities and I actually want to do it one to two 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 actually teach you about a new financial statement that we really haven't I don't think I've covered it all much and that's the income statement so far you're familiar with 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 at the beginning of year one and let's see let me see if I can recreate it I think I had said that I had originally capitalized this company with a million dollars that was coming from my savings or maybe I went to ten of my friends and they gave me a hundred thousand each but we don't care about how that equity was raised all we know is that we had a million dollars and then I had BOTS 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 a million dollars of real estate 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 it under in my backyard and you know 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 let's let's deposit some of our savings with him so I get 10 million dollars of deposits and of course I told them that look this isn't alone although it kind of is I'm not borrowing this money from you you guys can use this money whenever you need it and and because of that I need to set some of this deposits aside in case someone comes the next day and says though you know I gave you that dollar yesterday I actually need that dollar now too I don't know pay pay for my my my teeth cleaning or something so I need to set aside some of it and I figure well as 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 dollars of cash 1 million dollars of cash if I thought for some reason that there's a higher likelihood of all 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 what 9 million dollars right the gave me 10 I put one aside I'm left with 9 million dollars to loan out to this is productive capital and when I say capital that's just a a claim on someone's goods and services that can be used to construct or perform something that adds value that 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 in our society today we get 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 you know I've met people who become obsessed with well actually you know like on Khan Academy 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 but anyway so this is how my balance sheet looked at the beginning of year 1 and I said well I'm going to be getting in 10% on these loans and let's say that I 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 to 5% right so what happens over the course of that year so how much interest income am I going to get interest income interest income let's call that interest in tink interest income so 9 million times 10 percent I'm going to get $900,000 $900,000 and then what's my interest expense I probably should've done this in green but I think it's my interest expense interest expense well I had to I have to pay out 5% on the 10 million so it's $500,000 I'll put it as a negative number just you know it's an expense so since I said it's an expense you might want to put 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 this bet you know 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 so 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 salaries let's say I have to pay I don't know let's say it's - 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 upkeep upkeep I have to install new marble tiles every now and then to make because I have to project this impression of the shining impenetrable fortress so upkeep is actually a big expense of me so I spend 50k on upkeep and so what am I left with see 900 minus 500 is 400 minus another hundred so I'm left with 300 thousand 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 my cell phone is ringing but I'll ignore it it's very hard to ignore but anyway this is my pre-tax income but my local village government says no well you know you have to pay for the army and all of the other services that we provide so they take 30% so income taxes income tax income tax they take let's say say they take one-third so they take okay and so what am I going to be left with what is my net income net income 300 - 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 a big nice box around it just 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 at the end of the year given that this is how much money I made well say those loans they 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 loan so if I still have nine million dollars of assets which are those loans then paid them off I still have I still have the building and actually since I spent 50,000 on upkeep all of the wear and tear was kind of made up for with my upkeep so it's still worth a million dollars so I still have a million dollar building nine 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 million dollars of cash over the course of the year I show right here I made $200,000 and this two hundred thousand is essentially going to be cash now so now I have 1.2 million of cash 1.2 million of cash my deposits haven't changed I still have 10 million of deposits 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 point 2 million of total assets minus my total liabilities minus so I have 1.2 million now of equity 1.2 million of equity now something interesting has happened what has been my change in equity I had 1 million dollars of equity now I have 1.2 million dollars of equity so my change in equity so 1 million to 1.2 million dollars 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 an income 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 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 and another way to think about the income statement at the end it'll tell you all of your inputs what money came in what Connie came out in the form of expenses and taxes etc and then you had 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 sheets equity will increase by that amount in a year and if you had a negative net income your balance sheets equity will decrease in a year so you could view 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 what's your return on equity well your initial equity was 1 million dollars how much money did we make well the it grew by $200,000 so 200,000 over 1 million well you know we could think we could call that 1000 thousands that equals a 20% that was our return on equity right we we put in a million and we got 20% more than that that was our return on equity equals roee I 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 net income divided by starting equity and we well I'm defining it as starting equity sometimes people talk it is river average equity and all of that but 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 it all connects because that's the that's kind of the beauty of accounting is that you have these these different financial statements that are actually 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