Circular References in Financial Models

What is a circular reference?

A circular reference is when a cell refers to itself directly or indirectly.

Are circular references bad?

In most cases, a circular reference should and can be avoided with some planning. However, in a complex financial, I found it easier to just use circular references in certain areas.

Circular References in Financial Models

Circular references are used to help calculate cash balances. Let’s walk through two typical cases.

Interest

The cash sitting in the bank generates interest. The interest income is taxed and lowers the net income. More cash -> more interest -> more tax -> lowers net income -> effects cash.

See the example below. To determine the amount of interst, we use an average of the forecasted beginning and ending cash balances. It’s not fair to use just the beginning or the ending cash balances to calculate interest because over the time period that balance will change. Continue reading “Circular References in Financial Models”

How to Balance Your Balance Sheet

One of the hardest parts of building a financial model is getting the balance sheet to balance, meaning the basic equation of Assets = Liabilities + Shareholder’s Equity is true.

The balance sheet itself is not the problem, it is usually the cash flow statement that introduces the error.

Here are some tips to make sure your cash flow statement is correct to ensure you calculate the correct ending cash balance.

For a working model, start with the basic financial model.

General

Make sure you rebuild the historical cash flow statement with formulas, that’s the only way to ensure you’ve accounted for all numbers and everything will flow going forward.

All line items on the balance sheet must be used in the cash flow statement. Continue reading “How to Balance Your Balance Sheet”