Lesson 6 of 8
The interest circularity
Interest needs a debt balance, the balance needs the cash shortfall, and the shortfall needs interest. Three honest ways to break the loop, and one bad one.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The loop is real: interest expense depends on debt, debt depends on the cash shortfall, the shortfall depends on net income, and net income depends on interest.
- Break it with opening balances, with one explicit iteration, or with a fixed schedule from the maturity note, and say which you used.
- Costco's fiscal 2025 interest expense of 154 million dollars against average long-term debt of about 5,754 million implies roughly 2.7 percent.
Every three-statement model contains one genuine circle. It is not a bug in the arithmetic; it is a property of the thing being modelled, because a company that borrows to cover a shortfall pays interest that widens the shortfall.
The loop, and where to cut it
- 1Interest expenseSet by the debt balance and a rate
- 2Net incomeReduced by the interest
- 3Cash generatedFollows net income
- 4Debt drawn or repaidCovers the shortfall, and sets interest again
Then back to step 1, Interest expense.
The three honest breaks
Use opening balances. Compute interest on the balance at the start of the year rather than on the average. The loop disappears because the opening balance is known before anything else in the year is computed. It slightly understates interest in a year of heavy borrowing and slightly overstates it in a year of repayment.
Iterate once, by hand. Compute interest on the opening balance, run the model, read the closing balance, recompute interest on the average of the two, and run it again. Two passes is almost always enough, and every intermediate figure is inspectable.
Fix the schedule. Take the debt balances from the maturity note, which states what is due and when, and treat them as given. This is the most defensible approach when the company is not expected to need new borrowing, and it makes the model say clearly that it is not forecasting a financing decision.
The bad break
Switching on iterative calculation and letting the spreadsheet converge. It works, it hides the assumption, and it produces a model whose interest expense nobody can derive by hand. The first time a circular model gives a strange answer, nobody can tell whether the answer or the convergence is wrong.
What the rate should be
Costco's interest expense was 154 million dollars in fiscal 2025, 169 million in fiscal 2024 and 160 million in fiscal 2023. Long-term debt excluding the current portion was 5,713 million at 31 August 2025 and 5,794 million a year earlier.
Against the average of those two balances, 154 million is about 2.7 percent. That is a blended rate across issues made at different times and it is the right starting point for a model, because it is the rate the existing debt actually carries. A new borrowing would come at today's rate, which is a separate assumption to state.
The other side of the same line
Interest income and other, net was 589 million dollars in fiscal 2025 against cash and short-term investments of 15,284 million at the year end and 11,144 million a year earlier. The line combines interest earned with other items, so it cannot be read as a clean yield, and a model should hold it as its own assumption rather than derive a rate from it.
Check yourself
Why is the interest circularity a property of the business rather than a modelling error?
- Because spreadsheets compute in a fixed order
- Because borrowing to cover a shortfall creates interest that widens the shortfall
- Because interest is tax deductible
Show the answer
Answer: B.
The loop exists in the company as much as in the model. The model's job is to resolve it in a way a reader can follow.Which method makes the model's interest expense underivable by hand?
- Computing interest on the opening balance
- Iterating once and using the average balance
- Enabling iterative calculation and letting the spreadsheet converge
Show the answer
Answer: C.
Convergence gives an answer with no visible steps. When a circular model produces something strange, nobody can separate the answer from the convergence.What rate does Costco's fiscal 2025 interest expense imply on its long-term debt?
- About 0.3 percent
- About 2.7 percent, being 154 million against an average balance of roughly 5,754 million
- About 9 percent
Show the answer
Answer: B.
It is a blended rate across issues made at different times, which is the right starting point for existing debt and not the rate a new borrowing would carry.Sources
- Costco Wholesale Corporation, Form 10-K for the fiscal year ended 31 August 2025, filed 2025-10-08, accession 0000909832-25-000101: interest expense, interest income and other net, long-term debt excluding the current portion, cash and cash equivalents, and short-term investments.
What this leaves out
- The implied rate of about 2.7 percent uses long-term debt excluding the current portion, because that is the line disclosed on the balance sheet extract used here. Including the current portion would lower the implied rate.
- Interest income and other, net, combines interest earned with other items, so no yield is computed from it in this lesson.
- The iteration table uses invented round inputs except the opening rate, and is labelled illustrative.
- Nothing here is a view on Costco or on any security.