BIBLIOGRAPHY AND REFERENCES
5. To model interest expense
3.6 MODELLING INTEREST AND CIRCULAR REFERENCES
missing from a complete balance sheet. Like the other current assets account, other liabilities has a declining trend year over year, probably due to the decline of SteelCo’s activity, and is set constant at the last actual year’s amount which is €2,147k.
Exhibit 3.17 shows the balance sheet with all the forecast accounts up to 2017 except the retained earnings and short-term debt accounts. Note that the FP&A has made use of an in-built error check that raises the alert that the balance sheet does not balance (last line of the balance sheet of Exhibit 3.17). This issue will be resolved in the next section. Moreover, given the way the balance sheet has been modelled, all the line items are either linked to the income statement directly, or determined through the creation of an assumption that is held to a different area of the model (e.g. the “Assumptions” worksheet). Tempting as it was, no hard-coded numbers have been entered! For example, CAPEX, Depreciation, DSO, DIO, and DPO are recorded elsewhere and pulled through to the balance sheet.
The FP&A is now approaching the end of the modelling process. The structure of the balance sheet has been built and in the next section they will attempt to balance it.
Owner’s Equity = Share Capital + Retained Earnings + Profit / (Loss) after Tax, Profit / (Loss) after Tax = f(Interest Expense) and
Interest Expense = f(Short-term Debt) = Interest Rate × Short-term Debt, where f() is a symbol that means a function of.
It is easy to understand that something is peculiar in the relationships above. The FP&A, in order to calculate interest expense, needs to know the actual amount of short-term debt and, in order to calculate short-term debt, needs to know the actual amount of interest expense.
This is a problem and is called Circular Reference in excel.
Thank goodness Excel has a solution to this problem! To resolve this issue the FP&A will make use of the iterative calculations feature of Excel (see Exhibit 3.18). He sets the recal-culation mode to MANUAL so that the model will iterate only when CALC (F9) is pressed.
He chooses the Files menu, then the Options menu, then the Formulas menu, and then selects the button to Manual in the Calculations Options. He also selects the Enable Iterative Calculations and sets the number of iterations to 1 (simply by entering 1 in Maximum Iterations).
The FP&A will now be able to see Excel re-estimate the plug figure and interest expense at each iteration. He could set the number of iterations higher (Excel’s default is 100), but Excel will converge on a solution after 5 or 6 iterations, so a setting of 1 is best to see the iterations in action. Every time he presses the F9 key he should see the worksheet change. After pressing
EXHIBIT 3.18 Setting Excel recalculation mode to manual and iterations to 1
the F9 key several more times the numbers stop changing, which means that the model has converged to a solution. Net interest expense for year 20XX is exactly:
Net Interest Year 20XX = 5.7 % × Long-term Debt + 6.7% of Short-term Debt − 1% of Cash Deposits,
Retained Earnings Year 20XX = Retained Earnings Year 20XX − 1 + Net Income Year 20XX,
and the balance sheet balances which means that the short-term debt has converged to a single number. Once the FP&A has seen how this works, they decide to have the model converge without having to press CALC (F9) several times. In order to do this, they set the number of iterations they want Excel to perform. They set the number of iterations back to 100, Excel’s default, and allow its computer to recalculate automatically.
The next figure shows the complete proforma income statement and balance sheet statements. Once again, the 3 formulae that enabled the financial statements to balance are as follows:
Net Interest for Year 2014 = Cell G33 = 5.7% × Cell G61 + 6.7% × Cell G62 − 1% × Cell G53, or
Cell G33 = 5.7% × €50,283k + 6.7% × €24,612k − 1% × €3,500k = €4,443k, Retained Earnings Year 2014 = Cell G58 = Cell F58 (Ret. Earn. 2013) + Cell G38 (Net Inc. 2014), or
Cell G58 = €810k + (− €1,885)k = − €1,076k, and
Short-term Debt for Year 2014 = Cell G62 = Cell G55 − Cell G59 − Cell G61 − Cell G63 − Cell G64, or
Cell G62 = €121,802k − €30,184k − €20,283k − €14,575k − €2,147k =
€24,612k.
By selecting the above cells G33, G58, and G62 and dragging them to the left the FP&A can forecast quite easily the net interest expense, retained earnings, and short-term debt for years 2015, 2016, and 2017 respectively (see Exhibit 3.19). It should be obvious by now how the 2 statements are interlinked.
Please always remember to verify that the check figure which has been implemented at the bottom of the balance sheet is zero. The zero check figure confirms that the balance sheet balances.
As a final note to this section I would like to stress that for many financial modelling organizations, circular references must be avoided as they have many drawbacks. The major problem with using circular references is that once you have one it is very difficult to distin-guish between mistakes that have created inadvertent circular references and the intentional circular reference. Although I try to avoid circular references whenever possible there are some cases where a circular reference gives a shorter solution than a non-circular variation of it. This is the case we described above. The interested reader can visit various financial mod-elling websites (e.g. corality.com1 or chandoo.org2) and find alternatives on how to overcome circular references. Meanwhile I will give you a workaround in case you face a #Value error.
In this case Excel may be unable to find an acceptable answer due to another error in some of the cells of your workbook (e.g. due to a #DIV/0 error). First make sure you make all the
↓ ↓
Reads from the assumption sheet
↓
required changes so that you avoid that particular error (i.e. the #DIV/0 error). Then, if the
#Value error persists to the cells with the iteration, you have to break the circular reference and jump start the model. For example you will have to go to cells G62 to J62 and delete the formulae that created the circular reference in the first instance (or copy them to an adjacent empty cell). Replace them with a hard-coded number, say 10. You will see immediately that now the balance sheet does not balance. Also at the same time the #Value error will disappear.
Now you may rewrite the circular reference equation described above (or paste it back) so that the balance sheet balances again. Everything will now be just fine.