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