The best way to understand the balance sheet is to construct one yourself. So, let's construct a balance sheet in this session. Let me introduce an imaginary company called PEN company. First, let's talk about this company's financial activities in year one. An entrepreneurs starts PEN company with $3,000 of our investment, and $4,000 in loan. She purchases production equipment with a cash of $4,000. In action three, she purchases raw materials for $3,000 on credit. She didn't converts $2,000 worth of raw materials into products. She pays their labor costs of $500. In action five, she pays herself a salary of $1,000. She depreciates production equipment by 20 percent. In action seven, she sells all the products for $5,000, one-half for cash, and the other half on credit. At the end of the year, she pays all the accounts payable and interest on the loan. These aid actions summarize the financial activities of PEN company in year one. We will use this example later for other financial statements. So, please make yourself familiar with these actions. Let's construct a balance sheet of PEN company at the end of year one. In action one, an entrepreneur starts PEN company with $3,000 of investment and $4,000 in loan. So, at the end of action one, the company has $7,000 in cash and it is shown on the left side of the balance sheet. On the right side, it shows how she obtained the money, $3,000 of this owner's equity and $4,000 is a loan. So, the balance sheet after action one, will look like this. In action two, she uses $4,000 of cash to buy production equipment. So, there will be a decrease of cash by $4,000, But now, she has an equipment with the same value. There is no change on the right side. Now, you add the line one and the line two. That's the balance sheet after action two. She now has $3,000 of cash and $4,000 of equipment. The right side and the left side still balance. We know that balance sheet shows the financial status of the company at a certain moment. In action three, as she purchases raw materials on credit, there is no change in cash. Now, she has material inventory of $3,000, and she has accounts payable because she has not yet paid cash for the materials. So, it looked like this. Again, this balance sheet balances. Action four is production. She uses $2,000 of raw materials and pays labor costs of $500. There is a decrease of cash by $500 and a decrease of material inventory by $2,000, but now she has finished goods inventory of $2,500. In action five, she pays herself a salary of $1,000. There is decrease of cash by $1,000 and decrease of owner's equity with the same amount. Then she depreciates the production equipment by 20 percent. This 20 percent means that she expects to use this equipment for five years. So, the equipment value will be decreased by $800. Because the equipment is used for production, the value of this finished goods inventory is increased by the same amount as the depreciation, $800. Let me explain this more in detail. This slide shows raw materials graphically. After we begin production, we now have work in progress inventory. The value of the work-in-progress inventory is increasing because we are adding values such as manpower and use of the production equipment. We have finished goods inventory once the production is completed. In the warehouse, we have two kinds of inventories, raw materials inventory and finished goods inventory. If we look more closely at this finished goods inventory, there are three components, raw materials, labor, and depreciation of production equipment. In action seven, she sells all the products for $5,000, she receives one-half in cash. So, there is an increase of $2,500 in cash. Now, she has accounts receivable of $2,500, so it looked like this. She used up all the finished goods inventory, and so there is a decrease of $3,300 in finished goods inventory. With this transaction, she generates $1,700 of profit and that goes to owner's equity. Now, let's look at action eight. She pays all the accounts payable, which is $3,000 and also the interest on the loan which is 10 percent of $400. There is a decrease of cash by $3,400, decrease of $3,000 in accounts payable, and a decrease of owner's equity by $400. So, we have constructed the balance sheet of PEN company at the end of the year one. The last line in this balance sheet is at the end of the year one. Here I rewrote this balance sheet at the end of the year one. There are current assets like cash, accounts receivable, and material inventory and the total is $4,100. Here's the production equipment, and the remaining value is $3,200 after depreciation. On the right side, there is a loan for $4,000 and owner's equity $3,000, plus retained profit of $300. We will talk about this profit again when we construct the income statement. In summary, balance sheet shows the company's financial state at a certain moment. We now know that the balance sheet always balances.
