The Merchant of Venice - A balance sheet explanation, Q2 2025

The giant stone warehouse rose straight out of the water from the canal it bordered, except for a recess in the wall which created an unloading platform. In the corner of this platform sat an old wooden bench, its planks made from the same timbers as the massive doors next to it. On the bench sat Luca Pacioli. Luca was an unremarkable looking man, somewhat round, with the polled head of a Friar. However, inside that bald pate was a mathematical genius which intellectual giants like Leonardo DaVinci sought to be tutored by. The merchant who owned the warehouse was a friend of both Luca and DaVinci. When DaVinci was visiting from Milan, it was not uncommon to see all three of them sitting on the rough-hewn bench, discussing, debating, or simply watching the boats. Today, Luca sat alone, eating his lunch and flicking bits of it to a demanding sparrow who sat nearby. The water on the canal was almost a mirror as it curved away between the other buildings to join Venice’s network of canals.

He must have dozed, because when he opened his eyes, the sparrow was gone, and there were ripples lapping gently at the edge of the platform, foretelling the coming of a boat - probably a freight barge. A few moments later it showed itself around the corner, and Luca recognized the tanned face and stout arms of the man using a long pole to propel it. The barge master gave a friendly shout and a final push, and the barge glided into its slip for unloading. The oak doors next to Luca creaked upon their hinges and several men with strong backs appeared to begin unloading its contents. The Merchant followed with his tally book and sat next to Luca to oversee the operation. All along the canal, other barges pulled up to other places of business to perform the same operation. Lunch hour was over in Venice. 

Luca was in no hurry to leave. His friend the Merchant was an interesting man and Luca loved to watch the boats come and go. 

“How is business?” he asked.

“For me it is terrible,” growled the Merchant. 

“Well, you have lots of cotton,” observed Luca.

“This is thee problem,” hissed the Merchant. The price now is good. I vant to fill thee varehouse full. Later thee price will be high and I will have much cotton to sell from my full varehouse. But I do not have enough money to buy all thee cotton I need. Without money, thee business is bad.” He scowled at his tally book. “I need three more barges, then I would have my varehouse full. I only have money for one more.”

Luca pondered for a little before asking the obvious. “Won’t the banker loan you the money?”

“This is thee problem!” the Merchant exploded. “That little shrew vill not loan me any more money! He says I am too much risk because I do not show profit. Of course I can’t show profit! All my money is buying cheap cotton! He is an idiot!”

Luca stifled an unbecoming smile. He knew the banker well, a thin nervous little man. “Does he know the reason you have no profit is because your warehouse is nearly full of cotton?”

“Yes, yes! I tell him! But he only say he cannot see my cotton, he can only see my losses. I tell him come down to my varehouse full of cotton and see for yourself, and he say no, no, thee wharf is full of rats and criminals. Bah! I tell him thee rats on my dock have better business head than he does!”

The barge slid back into the now busy canal with a flourish of pole. The Merchant waved cheerfully in contrast to his grouchy words about the banker, and the barge master waved back with easy confidence and no apparent regard to his near collision with a passenger boat passing by. “Tomorrow!” was their mutual farewell.

“You see,” said the Merchant, “if that idiot banker had half thee sense of the average barge master, he vouldn’t be fussing about a balance sheet. Vhat is a balance sheet anyway? Vhen vill they stop coming up with new vays to complicate my business?”

Luca coughed discretely into his hand. The reason the banker even knew what the new-fangled term meant was because he, Luca, had given the banker a draft copy of his new book about business accounting. He hadn’t invented the idea of a balance sheet, but as far as he knew he was the only person promoting its use outside of theoretical university discussions, and he was the first to write a book about it.

The next hour was a pleasant and productive one as the two friends explored the purpose and usefulness of the balance sheet in the business of buying and selling bales of cotton.

“The balance sheet in its simplest iteration,” Luca explained, “is simply a listing of all the assets and liabilities of a company, along with what they cost. 

“Assets include anything of value purchased by the company. They include not only things like cotton inventory, but more permanent things like the warehouse itself, or the equipment in it. Cash is also listed on the asset side of the balance sheet.  

“Liabilities are easy to understand. They are listed on the opposite side of the balance sheet and are simply loans owed to other people by the company.

“It is possible,” explained Luca, “for assets and liabilities to equal, or balance each other exactly. For instance, when your Uncle gave you seed money to start the business years ago, for a moment in time, your assets, or the cash he gave you, exactly balanced the liability, or the debt you owed him. In fact, until you sold your first bale of cotton, the assets and liabilities exactly matched. Every dollar of your Uncle’s money that you spent on cotton lowered the cash you had, but raised the amount of cotton inventory by the same amount. The liability side remained unchanged, so assets and liabilities matched, or balanced. That’s where the term “balance sheet” comes from.”

“I have two questions,” said the Merchant, with a twitch in his mustache. “First, are you thee one who told the banker about this new-fangled complication? And second, what happened to thee balance on my balance sheet vhen I sold the first load of cotton? It’s easy to see that if I sold it for a profit, I now have more money than I started with, and now it will no longer balance with thee liabilities.”

“Ah my friend,” said the Friar, “The first answer may be somewhat distasteful, but the second is delicious.”

He went on to explain a third component to the balance sheet called Equity. “It sits as a companion to liabilities on the balance sheet, and always makes up the difference between assets and liabilities. Equity basically shows the net book value of a company on a given date. Like assets or liabilities, equity can have several lines. There is a line which shows what money the owner has contributed to or drawn out of the company. But the most important one perhaps, is called net income, which is simply the bottom line from our profit and loss for the year. When we sell a load of cotton for more than we bought it for, we do indeed end up with more cash than we originally started with. The increased amount of cash will be reflected in the assets on the balance sheet. It will also be on our profit and loss statement as a sale, thus, the increase in cash will be placed on the net income line of equity. Since equity sits along side liabilities on the opposite side of the balance sheet from assets, we again return to balance. The balance sheet equation,” said Luca as he rubbed his hands with delight, “is that assets must always equal liabilities and equity. It’s deceptively simple, but so powerful!”

The Merchant rubbed his chin. The concept itself was not so hard to understand, but he had one final question. “Friend Friar,” he said “you have done a fine job of explaining your new-fangled balance sheet, but you have failed to explain vhy I need one.”

“Ah,” said Lucas, “that is a good question with two answers; both of them delicious this time.” The first reason is that a proper balance sheet, along with the profit and loss statement you’re already familiar with, will give the banker a complete picture of your business without needing to mingle with the criminals and rats. He will be able to see that the money you are spending is not losses at all but an increase in your cotton inventory assets. Not only that, but a series of those reports over the course of time will tell him the direction of your business and help him make decisions about the risk he spends his nights worrying about. Secondly, because balance sheet accounting requires at least two entries with every transaction in order to remain in balance, it acts as a sort of automatic double check on every entry, eliminating most errors. This helps both you and your banker have confidence that the financial picture you are looking at is an accurate one. Isn’t it a thing of beauty?!”

The Merchant’s swarthy face folded into a grin. “It may be beautiful to you – a man of vords and figures- but vhat I think is beautiful is a varehouse full of cotton. And plenty of cats!”

The Arrow Team

Footnote: Luca Pacioli is considered the father of modern accounting. He was a tutor to many of the brightest minds of his day, including Leonardo DaVinci. He published “Summa” in 1494 which was the first published work on double entry accounting. 

“Pacioli dramatically affected the practice of accounting by describing the double-entry accounting method used in parts of Italy. This revolutionized how businesses oversaw their operations, enabling improved efficiency and profitability. The Summa's section on accounting was used internationally as an accounting textbook up to the mid-16th century. The essentials of double-entry accounting have for the most part remained unchanged for over 500 years. Accounting practitioners in public accounting, industry, and not-for-profit organizations, as well as investors, lending institutions, business firms, and all other users for financial information are indebted to Luca Pacioli for his monumental role in the development of accounting.” – from Wikipedia