What is a 3 Statement Financial Model?

Imagine a company thinking about diving into a new market. The finance team kicks things off by plugging in past financial data to build a solid foundation. Next up? They start making educated guesses like revenue growth, expenses, and other financial matters for this new venture.

By folding these guesses into financial statements, like the income statement and balance sheet, the team can peek into the future financial performance of the company. This deep dive helps finance and planning pros, business development teams, and investors see what could happen and what risks might be lurking. They can then weigh in on how this new move might shake up the company’s profits and cash flow, deciding if the potential gains are worth the gamble.

What Is a Three-Statement Model?

A three-statement financial model, or the three-statement model, is like the backbone of forecasting for a company. It lays out the income statements, balance sheets, and cash flow statements, forming a solid base for creating more complex models like merger models, DCF models, LBO models, and others you’ll find in the chart below.

3 Statement Financial Model Overview

Accounting helps us understand a company’s past financial records. But when we forecast using those statements, we can predict how a business might do under different scenarios.

These statements give finance experts and industry insiders a clear view of a company’s money moves and strategic choices. Like a backstage pass to business decisions:

  • FP&A analysts
  • Bankers
  • Institutional Investors
  • Private Equity
  • Sell-side Equity Research

Well-constructed three-statement financial models help these experts understand how different business activities influence the future bottom line. These statements are handy in financial reporting and closing, making it simpler to grasp how corporate financial choices impact overall business performance.

Key Components of a Three-Statement Financial Model

The integrated models are handy tools because you can tweak assumptions in one part to see how it affects the other areas. But, make sure you’ve got all the data points you need for your financial modeling.

At the very least, grab the latest SEC filings, equity research reports, and maybe some press releases from the company. Finding info on private companies can be trickier than public ones, and financial reporting rules vary by country.

When you’re working on a three-statement model, you’re juggling various outputs and schedules. These three key elements really nail down how all the numbers on the financial statements are connected.

1. Income Statement

Income statements, or profit and loss statements, show how profitable a business is for a certain period, like every quarter or year. They’re set up to cover at least three years of past data, helping calculate historical ratios and growth rates for future forecasts.

When you’re starting a three-statement financial model, you begin by putting in data from past income statements, either manually or from a press release. Financial planning kicks off with revenue predictions and then moves on to forecasting different expenses.

All this work helps estimate the company’s earnings per share and total income. Every line on an income statement affects the balance sheet or cash flow statement, making the income statement super important in financial modeling. For example, depreciation expenses impact asset values on the balance sheet and cash flow statements using the indirect method, since depreciation is a non-cash cost.

2. Balance Sheet

Income statements give a detailed view of how a company is doing over a period, while balance sheets show a snapshot of the financial state at a particular time. They reveal assets, funding sources, and more.

Revenue shapes the assumptions that drive operations, affecting balance sheets shown in income statements. These assumptions also impact expenses, working funds, and other financial aspects.

Imagine the balance sheet as a picture and the income statement as a story. The balance sheet displays the financial position on a specific day, detailing assets, debts, and equity. While not every change in the balance sheet impacts income or cash flow, many do. For instance, paying an old bill lowers accounts payable and shows as cash outflow, but doesn’t affect income.

3. Cash Flow Statement

When looking ahead at forecasts, you don’t need to first enter historical cash flow results. Just focus on year-over-year changes in the balance sheet from the cash flow statement. Each cash flow statement item can be linked back to other parts of the financial model.

Building a well-structured cash flow statement ensures your balance sheet remains accurate. To forecast cash flow, compare current and projected balance sheet accounts. The cash flow statement’s end balance should match the forecasted cash balance on the balance sheet.

The cash flow statement tracks cash coming in and going out, helping align accrued expenses, actual income, and cash transactions. This statement comes last as it draws from both the income statement and the balance sheet. Once these pieces are in place, you’ll have cash balances for all forecast periods.

Simple Steps to Create a Three-Statement Financial Model

To achieve accurate financial forecasts, it’s important to follow a systematic approach, ensuring that each step is diligently executed. Here are the steps we recommend you take when creating your three-statement financial model:

Step 1 – Enter Historical Financial Data

Begin by collecting and entering all relevant historical financial data into an organized Excel spreadsheet. This forms the foundation of your forecast, providing baseline figures for comparison and trend analysis.

Step 2 – Identify Key Predictions That Fuel Accurate Forecasting

Clearly outline the key assumptions and predictions that will influence your financial models. This can include projected sales growth rates, expected changes in expenses, market trends, and economic indicators.

Step 3 – Predict the Income Statement

Utilize the defined predictions to project future revenue, cost of goods sold (COGS), gross profit, operating expenses, and net income. This step helps in understanding the potential profitability of the business.

Step 4 – Predict Capital Investments and Assets

Forecast future capital expenditures (CapEx) and other significant investments in assets. This includes predicting depreciation and amortization expenses in line with the projected investments.

Step 5 – Predict Financing Activity

Anticipate changes in financing activities, such as new equity or debt issuance, repayments, and interest expenses. This step is important for understanding the financial structure and the impact of financing decisions on cash flow and leverage.

Step 6 – Predict the Balance Sheet

Using the previous predictions, forecast future assets, liabilities, and equity. This provides a snapshot of the company’s financial position at the end of each period.

Step 7 – Complete the Balance Sheet

Finalize the balance sheet by ensuring all assets equal the sum of liabilities and equity. Adjust for any discrepancies and make sure all accounts are balanced.

Step 8 – Complete a Cash Flow Statement

Compile a cash flow statement by detailing the cash inflows and outflows from operating, investing, and financing activities. This statement tracks the liquidity position and ensures the company can meet its financial obligations.

By following these steps, you can create a comprehensive financial forecast that provides valuable insights for decision-making and strategic planning.

Things to Consider in Financial Modeling

Before you start creating an Excel worksheet and begin modeling, consider the following points:

  • Assumptions – You will need to make various assumptions when building your model. These assumptions are crucial as they drive your model, so ensure they are reasonable based on historical data and future projections.
  • Modeling Errors – If you are new to building financial models, you may encounter errors in your Excel sheet. It’s a learning process, and you can improve as you go. For added confidence, consider taking a modeling course.
  • Bias – If you have studied behavioral finance, you’ll understand how bias can influence financial models and decisions. Strive to keep your assumptions objective to achieve more accurate forecasts.

Conclusion

Getting a clear picture of where a company is heading financially in the future using a solid three-statement model is so important. It helps finance folks play out different scenarios and see how it could affect profits, cash flow, and the company’s financial well-being. These models provide a great roadmap for dealing with uncertainties and help stakeholders make smarter decisions. By looking ahead with careful predictions and analysis, companies can boldly venture into new markets and growth paths, knowing they’ve got a solid and sensible financial insight.

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