Debt, interest, and circularity

Debt is the third supporting schedule, and the one that most repays being built carefully, because it feeds the model in several directions at once. The balance sheet needs the closing debt balance; the income statement needs the interest expense; and the cash flow needs both the interest paid and the principal repaid. Get the schedule right and all of those fall into place from one small block of rows. Get it wrong — most often by tangling the interest calculation into a circular knot — and it is the single most common reason a beginner's model will not balance, or will not calculate at all. This module builds Sokoni's debt schedule, links its interest into the income statement, and then confronts the two features that make debt genuinely hard to model: interest on a moving balance, and a revolver that flexes with cash.

The debt roll-forward

A debt schedule is a roll-forward, the same shape as the PP&E schedule: the closing balance equals the opening balance, plus any new drawdowns, less any repayments. Sokoni opens with 300,000 of debt, draws nothing new, and repays a contractual 50,000 a year, so the balance walks steadily down — from an opening 300,000 to a closing 250,000 in Year 1, then 200,000, 150,000, 100,000, and 50,000 by the end of Year 5. Drawdowns are zero here, but the line stays in the schedule deliberately, because the moment you add a revolver it is the drawdown row that comes alive. Each year's closing balance is the next year's opening balance, and it is this closing figure — not the average, not the opening — that sits on the balance sheet as the debt liability.

Interest is charged on the opening balance: twelve per cent of whatever the company owed at the start of the year. That gives an interest line of 36,000 in Year 1 (12% of 300,000), then 30,000, 24,000, 18,000, and 12,000 in Year 5 — a total of 120,000 across the five years. The line falls by exactly 6,000 each year, and it is worth seeing why: every 50,000 repayment permanently retires a slice of debt that had been costing 12% × 50,000 = 6,000 a year. That single interest number links straight into the income statement, below operating profit, where it turns Sokoni's EBIT into pre-tax profit; the tax line then applies to what is left. Because the charge is based on the opening balance — a number already known before this year's profit is calculated — the interest line can be computed in one clean pass, with no circular reference. Hold on to that; it is the reason the model chooses opening over average.

Opening balance, average balance, and circularity

Charging interest on the opening balance has one flaw: it slightly overstates the cost, because the company does not owe the full opening amount all year — it repays through the year, so its average debt is lower. The more accurate charge uses the average of the opening and closing balances. For Sokoni in Year 1 that is 12% × (300,000 + 250,000) / 2 = 12% × 275,000 = 33,000, a clean 3,000 below the opening-balance figure, and the same 3,000 gap recurs every year (twelve per cent of half the 50,000 repayment). On a fixed repayment schedule like this one the average-balance charge is perfectly computable and not, in itself, circular — every closing balance is known in advance. The circularity appears the moment the debt balance stops being fixed and starts depending on the model's own cash: interest reduces profit, profit feeds cash, cash decides how much debt is drawn or swept, and the drawn debt sets the very balance the interest is charged on. That loop — interest to profit to cash to debt to interest — is the circular reference you met in Module 5, and the average balance is the first step onto it. This is why so many production models keep interest on the opening balance: they trade a few thousand shillings of precision for a model that computes cleanly and never spins.

The revolver and the cash sweep

A revolver — a revolving credit facility — is the shock absorber of a financial model. It is a line of credit the company can draw on when it is short of cash and repay when it has cash to spare, and modelling it is how you stop a forecast from showing an impossible negative cash balance. The logic is a switch: work out the cash the business has before touching the revolver; if that figure is below the minimum the company wants to keep in the bank, draw exactly enough on the revolver to top it back up to the floor; if it is above the minimum, sweep the surplus to repay any revolver balance outstanding. Sokoni needs one. Recall from the previous module that once it funds its growth capex, its 50,000 debt repayment, and its dividend, its cash balance falls to 32,355 in Year 1 and turns negative in Year 2 — the model as it stands is insolvent on paper. A revolver is what funds that shortfall: it draws down to hold cash at the floor, and the company carries a revolver balance that grows until its operating cash flow finally outpaces its reinvestment and debt service.

Mandatory versus optional, and what the lender watches

Not all repayment is the same, and the distinction drives the schedule. Mandatory repayment is contractual — Sokoni's 50,000 a year is an amortisation the loan agreement requires, paid whether or not the company can comfortably afford it. Optional repayment is discretionary: a company sitting on surplus cash may choose to prepay a term loan early, and a revolver sweep is optional repayment by design, made only when and to the extent cash allows. A well-built schedule keeps the two on separate rows, because a lender treats them very differently — mandatory amortisation is a fixed claim on cash that ranks ahead of dividends, while optional prepayment is a use of cash the company controls. The order in which cash is applied — interest first, then mandatory amortisation, then sweeps and dividends — is the waterfall, and it is the backbone of any leveraged model. The downloadable model at /templates/3-statement-financial-model builds Sokoni's debt schedule and this waterfall in full, with the interest already linked into the income statement.

• Net debt / EBITDA — the headline leverage ratio: total debt less cash, over EBITDA. It answers 'how many years of cash earnings would it take to repay the debt?' Sokoni's gross debt / EBITDA falls from 1.4× at the opening (300,000 / 220,000) to 0.2× by Year 5 (50,000 / 322,102) as debt amortises and EBITDA grows.
• Interest coverage (EBIT / interest) — how many times operating profit covers the interest bill. Sokoni improves from 4.7× in Year 1 (170,000 / 36,000) to 19.7× in Year 5 (235,969 / 12,000). EBITDA / interest is the same idea measured one line higher.
• DSCR — debt-service coverage: cash available for debt service over interest plus mandatory principal. Below 1.0× the company cannot meet its debt payments out of operations.
• Covenants — the thresholds a lender writes into the agreement, almost always on exactly these ratios: a maximum net debt / EBITDA (say 3.0×) and a minimum interest cover (say 3.0×). Breaching one is an event of default, so a good model reports the covenant headroom every year. Read together, Sokoni clears both comfortably and deleverages under its own steam — reassuring on the income statement, until you recall from the previous module that it is running its cash balance into the ground to do it, which is exactly why the debt schedule must be read next to the cash flow, never on its own.