Learn about Banking 2: A bank's income statement Video

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Learn about Banking 2: A bank's income statement

Learn about Banking 2: A bank's income statement Let’s go over that example that I gave in the last video where I am in this village and I started a bank to kind of match up savers with investment opportunities. And I actually want to do it one to hit point home a little bit more about how a bank can make some 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 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, at 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 a million dollars; that was coming from my savings or maybe I went to ten of my friends and they gave me a 100,000 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 bought a building that I could put money in that looks really safe and people would feel secured giving that money, putting that money into that building. So let’s say I had a million dollars of real estate; 1,000,000 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, “Wow! That’s the safer place to put my money than in my mattress or bury 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 out village. So 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 a loan although, it kind of is. I am 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 and says, “You know I gave you that dollar yesterday. I actually need that dollar now to—I don’t know—pay for my teeth cleaning or something.” So I need to set aside 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 are some type of strange run on the bank. So I am 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 what? $9 million dollars, right? They gave me 10. I have to put one aside. I’m left with $9 million to loan out to—this is productive capital and when I say capital, that is 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 what’s used. So that is $9 million of loans. And I know I always keep talking in those terms and I do that because I think in out 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—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 look at the beginning of year one. And I said, “Well, I am going to be getting in 10% on these loans.” And let’s say that I am very good and none of them default and I really do get my 10%. And I said that I am 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. Let’s call it interest Int Inc. Interest Income. So 9 million × 10%, I am going get $900,000. And then, what’s my interest expense? I probably should have done this in green but I think—what’s my interest expense? Interest Expense. Well, I have to pay a 5% on the 10 million. So it’s $500,000. I’ll put it as a negative number, so just you know it’s an expense. Although 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. So let me put it as -$500,000. And then to operate this bank—this bank—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 have 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. I have to install new marble tiles every now and then to make—because I have to project this impression of designing impenetrable fortress so upkeep is actually a big expense to me so I spend 50k on upkeep. And so, what am I left with? See 900 - 500 is 400 minus now the 100 so I am left with 300,000 but even though this is primitive village that I live in, it’s not so primitive that it does not have taxes. And so, this is my pretax income. My cellular phone is ringing but I’ll ignore it. It’s very hard to ignore but anyway, this is my pretax 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. They take—let’s say they take 1/3 so the take a 100k. And so, what am I going to be left with? What is my net income? Net income. 300 - 100, I am left with 200k. Fair enough and just so you know, this is the income statement. I am going to talk a little bit about how all of these match up. So let me draw a big, nice box around it so just it looks like a proper statement of something. So what does my balance sheet going to look like at the end of the year given that this is how much money I’ve made? Let’s 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 loans. So it’s nice to 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 to 50,000 on upkeep all 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, 9 million of loans outstanding. I had a million dollars of cash and now, how much cash do I have? Well, I have that million dollars before and I am 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 deposits. Million dollars of cash; over the course of the year, I show right here, I made $200,000. And these 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. So it’s reliabilities because I owe them to the people who have deposited their money with me. I owe them money. And so what am I left with? What is my equity? My equity is 1 million. What is my equity now? Well, equity is just total assets minus total liabilities, so what are my total assets now? 9 + 1 is ten + 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. 1.2 million of equity. Now, something interesting fact and 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 dollars, so we call it—if you’re used to the math’s notation, you could use that delta notation. Triangle; this 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 casual statement. Well, in 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 it, the income statement at the end, it will tell you all of your inputs, what—your money came in, what—money came out in the form of expenses and taxes, etc. And then your 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 have a negative net income, you’re 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’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, you know, we could say—we could call that 1000 thousands. That equals a 20%. That was our return on equity, right? We put in a million and we got 20% more than that. That was out return on equity—equals ROE. 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 starting equity and we—well, I am defining it as staring equity. Sometimes people talk it as 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 kind of the beauty of accounting; is that you have 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.

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Learn about Banking 2: A bank's income statement

Let’s go over that example that I gave in the last video where I am in this village and I started a bank to kind of match up savers with investment opportunities. And I actually want to do it one to hit point home a little bit more about how a bank can make some 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 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, at 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 a million dollars; that was coming from my savings or maybe I went to ten of my friends and they gave me a 100,000 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 bought a building that I could put money in that looks really safe and people would feel secured giving that money, putting that money into that building. So let’s say I had a million dollars of real estate; 1,000,000 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, “Wow! That’s the safer place to put my money than in my mattress or bury 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 out village. So 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 a loan although, it kind of is. I am 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 and says, “You know I gave you that dollar yesterday. I actually need that dollar now to—I don’t know—pay for my teeth cleaning or something.”

So I need to set aside 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 are some type of strange run on the bank. So I am 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 what? $9 million dollars, right? They gave me 10. I have to put one aside. I’m left with $9 million to loan out to—this is productive capital and when I say capital, that is 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 what’s used. So that is $9 million of loans.

And I know I always keep talking in those terms and I do that because I think in out 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—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 look at the beginning of year one. And I said, “Well, I am going to be getting in 10% on these loans.” And let’s say that I am very good and none of them default and I really do get my 10%. And I said that I am 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. Let’s call it interest Int Inc. Interest Income. So 9 million × 10%, I am going get $900,000. And then, what’s my interest expense? I probably should have done this in green but I think—what’s my interest expense? Interest Expense.

Well, I have to pay a 5% on the 10 million. So it’s $500,000. I’ll put it as a negative number, so just you know it’s an expense. Although 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.

So let me put it as -$500,000. And then to operate this bank—this bank—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 have 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. I have to install new marble tiles every now and then to make—because I have to project this impression of designing impenetrable fortress so upkeep is actually a big expense to me so I spend 50k on upkeep.

And so, what am I left with? See 900 - 500 is 400 minus now the 100 so I am left with 300,000 but even though this is primitive village that I live in, it’s not so primitive that it does not have taxes. And so, this is my pretax income. My cellular phone is ringing but I’ll ignore it. It’s very hard to ignore but anyway, this is my pretax 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. They take—let’s say they take 1/3 so the take a 100k.

And so, what am I going to be left with? What is my net income? Net income. 300 - 100, I am left with 200k. Fair enough and just so you know, this is the income statement. I am going to talk a little bit about how all of these match up.

So let me draw a big, nice box around it so just it looks like a proper statement of something. So what does my balance sheet going to look like at the end of the year given that this is how much money I’ve made?

Let’s 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 loans. So it’s nice to 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 to 50,000 on upkeep all 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, 9 million of loans outstanding.

I had a million dollars of cash and now, how much cash do I have? Well, I have that million dollars before and I am 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 deposits. Million dollars of cash; over the course of the year, I show right here, I made $200,000. And these 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. So it’s reliabilities because I owe them to the people who have deposited their money with me. I owe them money.

And so what am I left with? What is my equity? My equity is 1 million. What is my equity now? Well, equity is just total assets minus total liabilities, so what are my total assets now? 9 + 1 is ten + 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. 1.2 million of equity.

Now, something interesting fact and 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 dollars, so we call it—if you’re used to the math’s notation, you could use that delta notation. Triangle; this 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 casual statement. Well, in 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 it, the income statement at the end, it will tell you all of your inputs, what—your money came in, what—money came out in the form of expenses and taxes, etc. And then your 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 have a negative net income, you’re 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’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, you know, we could say—we could call that 1000 thousands. That equals a 20%. That was our return on equity, right? We put in a million and we got 20% more than that. That was out return on equity—equals ROE.

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 starting equity and we—well, I am defining it as staring equity. Sometimes people talk it as 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 kind of the beauty of accounting; is that you have 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.

Transcription by: Scribe4you Transcription Services