The Revolver & Circularity
A revolver auto-funds cash shortfalls, but the interest it charges loops back into net income - the classic circular reference.
- ✓Describe the revolver as a secondary plug
- ✓Explain the interest circularity and how it is handled
A revolving credit line that the model draws on automatically when the business would otherwise run out of cash, and repays when cash is ample. It is the secondary plug that keeps cash from going negative.
The charges interest. Interest reduces , which reduces cash, which forces more borrowing, which adds more interest. -> cash -> -> interest -> is a genuine .
Modelers tame this two ways: compute interest on the average debt balance to dampen the loop, and enable iterative calculation so the spreadsheet resolves the circularity. A 'circularity switch' is often added so the loop can be broken if the model errors out.
What causes the circular reference in a three-statement model with a revolver?