Introduction to Balance Sheets | Housing | Finance & Capital Markets | Khan Academy

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..

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