Circular References in Financial Models: When They're Useful and How to Manage Them

In the world of financial modelling, accuracy and clarity are paramount. Whether you're building a forecast for a corporate budget, structuring a complex project finance model, or assessing a merger or acquisition deal, the structure of your model directly impacts the quality of your outputs. One topic that often generates debate among financial professionals—especially in Excel—is the use of circular references. Are they dangerous? Are they helpful? Should they be avoided at all costs, or can they be managed with care?

This article explores circular references in depth, clarifies when they can be useful, discusses how to manage them properly, and provides insights tailored to UK-based professionals. Whether you’re an in-house analyst, a finance director, or a financial modelling consultant, understanding how to handle circular references effectively can save you from costly errors and boost the credibility of your work.

What Is a Circular Reference?

A circular reference occurs in a financial model when a formula in a spreadsheet refers directly or indirectly to its own cell. For example, cell A1 refers to B1, and B1 in turn refers back to A1. This loop means Excel cannot calculate a result in a straightforward, linear fashion. Without proper management, circular references can cause errors, miscalculations, or even cause the model to crash.

In practical terms, circular references often arise in financial models dealing with items like:

Interest calculations based on cash balances

Deferred tax liabilities

Revolving credit facilities

Target debt/equity ratios

Circular dependency between net income and retained earnings

These features are common in corporate and project finance models, which are widely used across industries in the UK—from renewable energy projects in Scotland to real estate developments in London.

Why Are Circular References Controversial?

Circular references are controversial because they challenge Excel's native calculation logic. By default, Excel does not allow them and will alert the user with a warning when it detects one. You can, however, enable iterative calculations in Excel settings, which allows Excel to loop through calculations a set number of times or until a particular tolerance level is reached.

But here lies the issue: if the model isn’t built with precision, the iterative process may not converge (i.e., arrive at a stable result). Worse still, it could produce different results each time the file is recalculated—an unacceptable risk for financial reports and investment analysis.

Many financial professionals in the UK prefer to avoid circular references altogether. This is especially true in sectors with strong regulatory or audit scrutiny, such as banking, insurance, or government contracting.

When Circular References Can Be Useful

Despite the risks, circular references can be useful—sometimes even necessary—in specific modelling situations. Here are some real-world UK-based use cases where circularity adds value:

1. Interest Calculations on Cash Balances or Debt

In corporate models, interest expense is a function of average debt, but debt itself depends on available cash and operating performance—leading to a circular reference. Modellers can use a circular loop to estimate interest expense based on the ending cash balance, which in turn impacts net income and thus cash flows.

2. Revolving Credit Facility (RCF)

An RCF is used to bridge cash shortfalls, and the amount drawn from the facility depends on the cash position, which itself depends on financing costs. This inherently creates a circular reference. Many project finance models in the UK energy sector incorporate circular logic to determine optimal drawdowns and repayments.

3. Retained Earnings and Net Income Loop

In some models, retained earnings are used to calculate equity, which affects interest-bearing debt through a fixed gearing ratio. However, net income also affects retained earnings, creating a loop. In scenarios like leveraged buyouts (LBOs), this circularity is often deemed acceptable for realism.

4. Tax Shield Effects

When calculating deferred taxes or the impact of interest on taxable income, tax expense becomes both an input and an output. This too leads to circularity, especially in models built for infrastructure projects in the UK that involve long-term debt.

In each of these cases, a financial modelling consultant may deliberately introduce circularity to reflect economic reality more accurately—so long as the model is tightly controlled and transparently documented.

How to Manage Circular References Effectively

If you determine that a circular reference is necessary, the goal is to manage it properly to ensure the model is robust, understandable, and auditable. Here’s how to do that:

1. Turn On Iterative Calculations

In Excel:

Go to File > Options > Formulas

Check the box for “Enable iterative calculation”

Set maximum iterations (e.g. 100) and maximum change (e.g. 0.00001)

These settings ensure Excel attempts to resolve the loop by repeatedly calculating until it stabilises.

2. Use Flags or Switches

Control when a circular calculation is allowed to run. For example, use an IF statement that only activates circular logic after the model has stabilised. This is particularly helpful in models used for scenario planning or in UK infrastructure bids with multiple financial close scenarios.

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=IF(Iteration_Trigger = TRUE, Circular_Calculation, Non_Circular_Alternative)

3. Document Clearly

Always flag where circular references exist and why they are necessary. Use named ranges, clear comments, and dedicated audit sheets. If your model might be reviewed by external auditors or investors, especially in the UK market, clarity and transparency are key.

4. Use a Plug

A common technique is to create a balancing item (called a “plug”) that absorbs the circular calculation. For instance, an RCF plug can balance funding gaps without causing uncontrolled feedback loops.

5. Isolate the Circularity

Keep the circular component in a separate part of the model—ideally on its own sheet. This way, it’s easier to trace and debug. For example, having a “Circular Calcs” tab in your workbook can separate complex logic from operational assumptions.

6. Stress-Test the Model

Run the model under extreme assumptions to ensure it still converges. If a small change in assumptions causes wild fluctuations, then your circular logic may need refinement. UK investors and credit committees often insist on model sensitivity checks before approving projects.

Alternatives to Circular References

When possible, consider alternatives. Sometimes you can avoid circular references entirely by:

Using lagged values (e.g., using last year’s interest to calculate this year’s net income)

Approximating with fixed inputs (e.g., assume average debt balance instead of calculating dynamically)

Building macros/VBA to control the order of calculation

A seasoned financial modelling consultant will often weigh the pros and cons of circular versus non-circular logic and present both options to the client. In some regulatory environments (such as the UK public sector), circular references may be disallowed entirely, making alternatives a necessity.

Common Pitfalls to Avoid

Even when circular references are intentional, there are several traps to avoid:

Unconverging Calculations – If your loop never settles, your model becomes unreliable.

Multiple Circular Loops – Try to avoid nested or overlapping circular references; they’re very difficult to audit.

Unnecessary Complexity – Don't use circular logic where simple algebra would suffice.

Hidden Circularity – If a model contains accidental circular references, it can be incredibly hard to trace and fix. Use Excel tools like “Trace Precedents” and “Error Checking.”

The Role of a Financial Modelling Consultant

A financial modelling consultant brings both technical skill and industry experience to help organisations build robust, scalable, and investor-ready models. In the context of circular references, consultants:

Advise whether circularity is appropriate

Implement and test iterative logic

Provide documentation and version control

Train in-house teams to manage models going forward

For UK companies working in sectors like real estate, infrastructure, renewables, or private equity, partnering with a consultant ensures compliance with investor expectations and audit standards.

Circular references in financial models are not inherently good or bad—they’re tools, like any other. When used thoughtfully and managed carefully, they can add realism and flexibility to your financial analysis. But they come with risks that must be mitigated through best practices and professional judgement.

For finance professionals in the UK—especially those working with investors, regulators, or complex financing structures—it's essential to understand when circularity is appropriate and how to manage it responsibly.

Whether you’re building an in-house model or working with a financial modelling consultant, the key is transparency, control, and a deep understanding of how your model behaves under pressure.