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  • 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