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Principles of Finance: Unit 2, Balance Sheet 14 Views


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Our little lemonade stand got started with a $5,000 loan. What to do now? Pay off the loan or franchise with the profits? What a "Sophie's Choice" we have on our hands here.

Language:
English Language

Transcript

00:00

principles of finance a la shmoop. balance sheet. okay so we're gonna add on

00:08

a bit of complexity to our proverbial lemonade stand image here. first we're [man sits in front of white board]

00:14

gonna think about our cash. how was the company started? well it got a loan five

00:19

grand from Grandma.com. she didn't want to charge us interest but our parents

00:25

made her. their real life matters kind of parents. so she charged us ten percent

00:30

interest or five hundred bucks a year. for as long as we were renting that five

00:35

grand. well at the end of our first year we have a financial decision to make. do

00:39

we want to pay off the loan fully? or spend our six grand in after-tax cash

00:44

profits on building a second lemonade stand? [equation]

00:47

well our gut will tell us which way is most profitable risk-adjusted and that's

00:52

what we'll do. well let's go back and restate our income statement to include

00:55

the interest we owe on the five grand we borrowed. and there we go so a couple of

01:01

interesting things to notice here. we added five hundred bucks in expenses via

01:06

actually accounting for our loan to start the company. well before we had

01:10

added that in we had six grand in net profits so it would be rational to think

01:15

that we've just added five hundred bucks in expenses and now our new net profits

01:20

number should be fifty five hundred but it's not. it's better than that. why ? taxes.

01:26

yeah that 500 bucks came before the government took its 25% bite out of us.

01:32

well essentially the government paid for a quarter of our interest expense. hmm

01:37

how's that work? and you can imagine that in very high tax situations the [cost spreadsheet shown]

01:41

incentive to borrow more money is much higher because the government

01:45

essentially covers a lot of those expenses in the form of your being able

01:48

to deduct the interest expense on the money the money you borrow against the

01:53

taxes you'd be paying on your profits. all right another interesting thing to

01:57

note here was that we generated five thousand six hundred twenty-five dollars

02:01

in cash during the year. our interest expense was five hundred dollars. we

02:06

generated way more cash than we had in interest expense meaning that our

02:11

bankruptcy risk here is very low. which is good. we wonder to ourselves so

02:16

how much money could I borrow if we wanted to go big with lemonade stands

02:20

R US. lemonade stand on every corner in the country .okay and so doing a little [boy celebrates in front of lemonade stand]

02:26

bit amusing on the math here like if our interest rate was 10 percent we're

02:30

generating with one stand over five grand in cash well couldn't we borrow

02:36

ten times that number of fifty grand? if we did a 50 grand borrow that'd be about

02:41

five thousand dollars in interest we'd still have more profits than interest.

02:45

how much would it cost to launch a new additional stand would that stand

02:49

cannibalize revenues from our first stand. mmm could we buy supplies cheaper

02:55

if we had more scale or size? how many licks does it really take to get the

03:00

center of line? oh never mind. okay so we wonder about

03:02

the ratios here that go behind debt. largely revolving around how much debt

03:07

could we borrow if we wanted to max out. well we know that banks focus on an

03:11

arcane term called EBITDA when they loan money. side note if we ever get a

03:17

large dog at shmoop we're gonna name him gonna EBITDA. well what is EBITDA anyway?

03:22

well it stands for earnings before interest taxes depreciation and

03:27

amortization and in our case here we'd calculate our EBITDA is our earnings of

03:32

five thousand six hundred twenty-five dollars but then we'd add back interest

03:35

of five hundred bucks and taxes of 1875. we don't have any assets. [EBITDA explained]

03:41

we're depreciating or amortized so that totals 8 grand and EBITDA. and we use

03:46

EBITDA to get rid of non apples-to-apples things like taxes and

03:51

interest which can change a lot over time with interest rates moving in taxes

03:54

being different different states different countries and so on. we do this

03:57

so that we have a clearer picture of the basic operating health of the company.

04:02

and it's often quoted as a multiple by banks when they think about appropriate

04:06

levels for loaning money in the form of a debt to EBITDA ratio. and a ratio of four

04:12

is often about as high as low risk seeking bank will ever want to. go four

04:17

times debt to EBITDA and that would mean that without paying enormous

04:21

interest costs lemonade stands our us could get a loan of about 32 grand give [man explains in front of a lemonade stand]

04:26

or take. that's four times that $8,000 they

04:29

or EBITDA. so for a moment let's think about maxing out our loans. if we

04:32

found a bank stupid enough or visionary enough to trust us with a loan for 32

04:38

grand and they charged us 10% interest amazingly well we can still make the

04:43

interest payment. the bigger question is could we then use the 32 grand to open

04:48

up say six more lemonade stands at a cost of five grand each ? and still have

04:53

two grand left over for whatever. all right well at first blush our

04:58

projections say yes . and if each of those six stands could themselves generate

05:03

something like five grand a profit at the end of their first year like the

05:06

first one did well then wow we could pay back all of the loans in just one year. [equation]

05:11

and hmm that feels a lot like how Starbucks got started.

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