One of the objectives I have for students who go through my rotation is to be able to read and understand two major business accounting documents: balance sheet and income statement. Since I’ve never been able to completely grasp a concept until I actually do it, I figured what better way to teach students these two financial statements than to have them prepare them on a hypothetical business. The hypothetical business in this exercise is simply the student, or You, LLC.

Revenue and Major Purchases

The exercise assumes that upon graduation students take staff pharmacist positions earning $100,000 per year as a salary (no bonus, no overtime, nothing too complicated!). Before they spend a dime, they know to start saving for retirement so they put 5% of their income away in the company 401k. In addition to their retirement savings, Grandma gives them $5,000 upon graduation to put away for a rainy day, Thanks Grandma!

While in college, they incurred $100,000 of student loans to pay for school and will pay them off over 15 years at a 5% interest rate. Since the old junker that got them through school needs a new transmission (and a new pharmacist can’t be seen driving around in something ugly), they get a great deal on a new car for $30,000 which they financed over 60 months at a low rate of 2.5%. Since they need a place to live and everyone knows it is so much smarter to buy a home rather than rent (yes, that is sarcasm), they purchase a $200,000 house putting 5% down and financing the rest at an amazing 4% over 30 years. After buying the new house they realize the cardboard box furniture that was fun in college now just isn’t civilized, so being the smart shopper that they are they buy $5,000 worth of new furniture fully financed at the retail store at 0% over 12 months! Wow! This takes care of the big stuff.

Bigger Paycheck, Bigger Budget

Now these new pharmacists have been broke college students for many years and are ready to enjoy the finer things in life. They decide to purchase the new iPhone so they can talk to Siri and get a great deal at just $100 per month. In order to charge their new iPhone they have to make sure their new house has electricity. They also splurge for cable and internet so they can watch reruns of Jersey Shore on MTV and blog about the episodes with their friends, adding utility bills of an average of $200 per month. No more Ramen Noodles and free haircuts from their roommate, now our young pharmacists are spending $500 per month on food and hygiene. Finally realizing that in order to legally put their car on the road and drive it to work, they need to spend $300 a month on gas and car insurance.

Exercise Assumptions

This exercise is built for typical students graduating today with a heavy student loan debt and trying to adjust to an income they may not be familiar with. To make this exercise a little easier, I assume their tax burden for the year will be at 30% (it gets pretty complicated when you talk about payroll taxes, capital gains, deductions, charitable giving, etc.). I also leave out private mortgage insurance and property taxes on their home loan, which possibly tack on another $2,000-$3,000 per year depending on where they live and who finances the loan. This exercise is based on a single person with a single income, so for students with families we have to tweak it to make it more applicable for their life.

One assumption that may upset a few college deans is the asset value of the degree earned at the college of pharmacy. I believe it could be argued that the intellectual property value and earning potential of a graduate with a Doctor of Pharmacy degree could be valued and calculated as an asset. For my students, I keep it simple and assume that their degree is worth exactly what they could make if they tried to sell it. Since the value of the degree is not in the paper it is printed on, the value of this asset is $0.00 for our exercise.

Discussion

The exercise is not meant to kill the dreams of my bright-eyed students, but to help them understand that earning a high income doesn’t equate to wealth. The income statement is meant to show how the cost of living can add up quickly and the importance of managing their finances based on an annual budget. The balance sheet piece shows students how to calculate their net worth at a given point in time.

One major difference between business and personal finance I try to point out during this exercise is the way businesses and individuals are taxed. In a simple example with a Limited Liability Company (LLC), the tax rate is similar to a person but the actual taxable amount for a business is quite different than for an individual. In my example, even though I refer to this as an LLC, I have the student account for taxes based on their top line revenue. If this were a real LLC, the tax rate would be applied after operating costs and before net income. Without getting lost in all the complication of the United States tax system, I want the students to understand a fundamental difference in taxation applied to individuals versus businesses.

The practice of creating financial statements for a hypothetical business is commonly used in undergraduate business classes. By making this example personal, students can really visualize their financial position upon graduation. I urge all of my students to continue this exercise beyond graduation and apply their real numbers to it on an annual basis (as many businesses would do).

You, LLC

Income Statement (New Practitioner Year 1)

Revenue $100,000.00 Pre-Tax Contribution to 401k (5,000.00) Tax (2012 income and payroll taxes)* (28,500.00) Cost of Goods Sold (Cost of College) (9,480.00) Gross Profit 57,020.00 Operating Cost (Cost of Living) Home Loan (not including PMI and taxes) (10,884.00) Car Loan (not including sales tax) (6,384.00) Furniture Loan (paid in full in 1 year) (5,000.00) Cell Phone Bill (1,200.00) Utilities (2,400.00) Food & Hygiene (6,000.00) Auto Expenses (Insurance, gas, repairs) (3,600.00) Total Operating Cost (35,468.00) Net Income $21,552.00

*Tax is applied to revenue before operating costs are deducted for a person, but taxes are applied after operating costs for a business reducing the business’ tax burden.

You, LLC

Balance Sheet (End of Year 1)

Assets (What you Own!) Cash (Cash on hand, Checking, Savings) $5,000.00 House (no depreciation) 200,000.00 Car (resale value after 1 year) 25,000.00 Retirement Account (401k) $5,000.00 Inventory (furniture and that fancy iPhone) 2,500.00 Doctor of Pharmacy Degree* 0.00 Total Assets $237,500.00 Liabilities (What you Owe!) Home Loan $186,700.00 Car Loan 24,300.00 Student Loan 95,406.00 Total Liabilities $306,406.00 Equity (What you are Worth!)** You, LLC value of 1 share ($68,906.00) Total Liabilities and Equity $237,500.00

*The PharmD degree is an asset that allows you to earn revenue, but for this exercise I set the value as $0.00 because no other person can buy it from you and be a pharmacist.

**Worth in the financial sense because you can’t put a real price on the worth of MY students!