Think back to that summer you made a lemonade stand and sold cool drinks to your neighbors. Do you remember how you went about creating the stand and operating it? Do you remember how you purchased supplies or how you spent your hard-earned money?
When working on that lemonade stand, you had different tasks to complete. You needed to find supplies and a location. To spread the word about your new business, you possibly had to ring on your neighbors’ doorbells. After a successful day of selling lemonade, maybe you decided to build a bigger stand to attract more people. You may have even wanted to build more stands with help from your friends.
Through operating the lemonade stand, you were introduced to the basics of corporate finance, a field of finance focused on the decisions a business makes. As the owner of the lemonade stand, your simple goal is to earn the most money. That is parallel with the essential goal of corporate finance, which is to maximize the value of a business. In this article, we will be walking through some of the tasks of creating a childhood lemonade stand. While taking a trip down memory lane, we will simultaneously introduce ourselves to the principles of corporate finance.
Funding Your Business
As you plan out your lemonade stand, you realize the money in your piggy bank will not be enough to buy supplies. You decide to show your parents your business plan and hopefully get some cash from them. They like the idea and agree to lend you the funds if you agree to share your daily progress with them and return their money with interest. While you believe returning them the money you borrow is fair, you don’t like the idea of paying them interest. However, they explain that they are taking on a risk by giving you money, and they realize they may never get their money back if you fail to sell lemonade. While that is a risk they are willing to take, they also want to ensure they are sufficiently compensated for that risk. After all, they explain that they could be putting that same money in a bank, which would provide them with interest. When they put money into the bank, they are taking a low-risk option because they are nearly guaranteed that they will receive their money back with interest. Because your business is riskier than the bank, they ask that the interest you pay them is a little higher than their bank does to compensate for the additional risk they are taking on. After a bit of negotiation, you agree to borrow only part of what you need from your parents and decide to invite two of your friends to join you with some of their funds instead. It will be more fun, and it will also reduce the money you borrow and the interest you will need to pay. You now have access to the funds to start your business!
You noticed that borrowing money didn’t come without a cost. It put you in debt, a term that is commonly used in corporate finance. Debt is a fixed amount of cash a person or business borrows and needs to pay back with added interest payments. Debt is considered a liability, which is the amount of money or resources you or your business owes. Even if you don’t profit from your lemonade stand, your parents will expect you to pay them back regardless. That is one important factor of debt, where no matter if your business is a success or failure, you are expected to pay your debt-holders back. In this scenario, because your parents are debt-holders, if you are unable to pay them back, they may start taking money out of your allowance.
Your friends who join your lemonade stand by pitching in with some funding are investors or part owners. Because they are helping you run the business, it is only fair that you share the profit with them. You could consider them to be shareholders in your business because they will also enjoy the profit if your lemonade stand is successful. Unlike your parents, however, if your stand does poorly, your friends will suffer a loss as well. You all realize that you may lose all the money from your piggy bank. It is risky, but you decide to jump in with both feet.
You are off to a great start! Your lemonade stand is up and running. Your sweet lemonade is the best in your neighborhood, your large buckets of ice keep it cool, and your tiny cups make it easy for buyers to take their lemonade on the go. These supplies are your current assets because they are short-lived. Current assets are liquid assets, which means they can be converted to cash in a short amount of time. Current assets, such as cash or products, are short-lived because they are consumed, sold, or used.
Along with your outstanding lemonade, you have the prime spot for your lemonade stand. Your stand is located right outside the football field in your neighborhood. That way, tired kids can come out of the field to get a drink of cool lemonade. Not only is your spot top-tier, but you are planning on convincing your parents to buy you a big sign for your lemonade stand. That way, your flashy sign can catch everyone’s attention. We would consider the tent, table, and the big sign to be long-lived assets. This is because they don’t get consumed daily, and in the case of the flashy sign, it is something you can use the next time you put up a lemonade stand.
Because you have a lot of friends in your community, people know about your lemonade stand. Your stand is backed up by your name, and you are confident your friends will be attracted to your products because they know you and will want to buy lemonade from you. In this case, your name and the name of your lemonade stall could be considered your intangible assets. Intangible assets add value to a business but are not physical in nature.
After a few hot summer days, you are swimming in cash. You decide you want to help your friend kick-start her bake sale with some funding. Although you are helping your friend, you will hopefully earn some money from your friend’s bake sale if it is successful. Because you are putting cash into different entities on behalf of your lemonade stand, you are making financial investments for your business. Financial investments are another type of asset that adds value because they generate cash flow.
Your top-tier location, outstanding products, and flashy signs are all considered to be assets because they add value to your small business.
Recording Your Values
Because you are now in debt to your parents, you want to make sure to stay organized so you can pay them back. To track your stand’s progress, you decide to keep a daily tally of the funds and supplies you have and the amount of money you still owe. Simply tallying the number of lemons used in a day and recording the amount of money you make and owe will allow you to have documentation regarding your business venture. These records will both help you keep track of your progress and allow you to share your progress with your parents. Sharing your success will not only make your parents proud but will also get them to trust you with their money.
As you keep a daily record of your inventory, whether it is to show your parents (the debt-holders) or just to stay organized, what you are doing is making an informal balance sheet, split between your supplies and debt. A balance sheet is a financial report of a business, split into assets (e,g. supplies) and liabilities (e.g. debt). To a business owner, it is an important record because it provides a snapshot of how well a business is doing by reporting its financial condition. That information can then be easily shared with investors and can also provide an indication of what the business is worth.
You have a couple of goals you want to meet with your lemonade stand. Besides paying back the money you owe to your parents, you also have an eye on the cool gadget you saw in the store a few weeks back. You want to earn enough to afford the gadget, and it’s your goal to buy it by the end of the summer. Your friends, who are part owners of the lemonade stand, also have goals of their own. To earn enough profit to compensate your parents and meet your own goals, goal-setting is important.
As business owners, you and your friends want to identify potential areas your small business can grow from. You all decide to set up a stand on the other side of the neighborhood so you can increase your sales and double your profit. Your idea of opening another stand is a potential investment because you will need to invest time, money, and energy into it. You are willing to put the work in because you expect a positive return that will increase your profit. The question that comes into play with this idea is “Will this investment have a worthwhile payoff?”
Shareholders and other investors in corporations around the world ask themselves the same question every time they decide to make an investment, open a new branch, merge, or expand. They are weighing investments, just like your friends and parents did when investing in your business. Much like your goal to earn enough to purchase the gadget, large corporations have their own goals and expectations from any investment they make. To quantify the potential of an investment, investors set a goal value as the minimum they are willing to receive in return. That minimum value is termed the hurdle rate, which is represented as a percentage return that the investor hopes to receive.
Opening a new stand across the neighborhood is a pretty risky investment. One reason is that even though the other side of the neighborhood has a lot of people, they don’t know you or your friends. For that reason, they may not be willing to buy from you. If, however, people are willing to buy lemonade, opening a new stand could be very successful in bringing more profit into the business. Instead of opening a whole new stand, you have the less risky option of getting more friends to help spread the word about your lemonade stand. However, you don’t think that will result in too many new customers because you have already rung many doorbells.
This scenario of weighing two potential investments implicitly involves weighing risk using the risk-return principle of finance. The risk-return tradeoff argues that as the risk of an investment increases, the potential return also increases. Investors will adjust their hurdle rate, or their goal on an investment, based on how risky it is. For example, an investment that is riskier will have a higher hurdle rate because the investor believes the return potential is higher. Vice versa, a less risky investment will be safer but will have a lower hurdle rate because it has a lower potential for return.
Because you have the option of either opening a new stand or getting more friends to advertise, you decide to compare them. Perhaps you estimate how much your sales will increase with each option while also accounting for how risky each option is. Whether your final decision is right or wrong, the estimates you make will have the same underlying goal that investors have when they evaluate hurdle rates. By comparing hurdle rates, businesses can differentiate riskier investments from safer investments and decide on where to invest based on their risk appetite.
Tasks and Jobs
To run a lemonade stand, there is a lot of work you and your friends need to get done. Splitting up tasks into different categories will allow for organization and efficiency. From collecting funding for your stand to deciding how to budget, there is much more to a lemonade stand than just selling lemonade.
To grow your lemonade stand, you decided to buy more supplies and buy a new stand. These decisions were made by evaluating your goals as a business. Just like your investment into a new stand will hopefully generate a higher cash flow, corporations pursue capital investments to increase their value.
To pay for your new stand, you needed to find ways to finance the purchase. You had some different options, from taking another loan from your parents to bringing more friends into your business so you can all split the costs. If you already owed your parents too much money, it would be beneficial to involve your friends in the purchase instead. If, however, you realize you do not owe your parents too much and you have too many friends involved in your business, you may want to stick to taking loans from your parents. After all, it is your business, and you don’t want too many cooks in the kitchen. This balancing act of deciding how to fund your investments is termed capital financing in corporate finance. In this scenario, your parents are debt-holders, while your friends are shareholders. Because you want to avoid being in too much debt, but don’t want your profits to be diluted because you have too many friends working at your lemonade stand, choosing how to allocate your finances is necessary to your business, just like it is necessary in corporate finance.
Who would have thought that your childhood lemonade stand used principles and decision-making skills the largest corporations in the world use as well? Your lemonade stand’s use of corporate finance principles conveys the much larger idea that corporate finance is a set of common-sense principles applied to any business venture, large or small. For that reason, despite the heavy terminology and complex models one learns in the formal study of corporate finance, we are able to draw a parallel between a simple lemonade stand and a multi-billion dollar business.