Finance guide: The 3-statement financial model explained

Learn how to create a 3-statement financial model and why the model is an important financial planning tool.
Author
Ken Boyd
Writer
Published
May 2, 2024
read time
1 minute
Reviewed by
Karen Mei
Updated
May 23, 2024

This post defines the 3-statement financial model and explains how it is created. You’ll learn the best practices for generating the model and how this financial tool can improve business forecasting.

Key highlights: 

  • The 3-statement financial model is used to forecast business performance using a variety of assumptions.
  • Businesses use the model to forecast the outcome of operational and financial decisions and to assess financial health. 
  • Financial software tools make it easier to create the model and reduce the risk of errors.

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What is a 3-statement financial model?

The 3-statement financial model integrates three financial statements: the income statement, the balance sheet, and the statement of cash flows. The statements are used to forecast business performance using various assumptions.

Business owners, investors, lenders, and analysts use the three-statement financial model for company analysis. The template is used for budgeting and projecting a business valuation.

What are the three financial statements?

The three financial statements are:

  • Income statement (statement of profit and loss): Reports revenue, expenses, and net income (net loss)
  • Balance sheet (statement of financial position): Presents assets, liabilities, and equity
  • Statement of cash flows: Separates all cash inflows and outflows into cash flows from operations, financing, and investing activities

Many companies also include statements of changes in equity when they provide financial statements to stakeholders. This report explains how the equity balance changed during a period. Net income, dividends, and other transactions impact the equity balance.

The statement of changes in equity is not included in the 3-statement financial model, and most SMBs do not use the report.

Why is the 3-statement model important?

There are several reasons why the 3-statement model is a valuable analytical tool:

Forecast the outcome of decisions

Businesses use the model to forecast the outcome of operational and financial decisions. Assume that a car manufacturer analyzes whether to outsource engine production to a supplier. The model can forecast revenue, expense, and cash using both scenarios.

Assess how well a business process functions

A product or service must undergo multiple stages of activity before it is complete. The three-statement model can determine the financial impact of the entire process.

For example, assume that a business fully automates the invoicing process. The model can compare the cost of the invoice software with the manual cost savings.

Is it necessary to create a 3-statement model before doing other kinds of financial forecasting and modeling?

Yes, it is necessary to create a 3-statement model before starting other types of analysis. Here are some of the benefits:

  • Report connections: The model reveals how the three financial statements are connected. The ending balance in the statement of cash flows is connected to the cash balance in the balance sheet. The income statement’s net income also connects to the balance sheet.
  • Accuracy: The data in each financial statement must conform with the formulas used to generate each report. Net income, for example, is calculated as the difference between revenues and expenses. When the financial statements are accurate, forecasts are more useful.

The three financial statements are necessary for these types of analysis. Investment banking staff, corporate finance managers, and other analysts use these types of financial models:

  • Discounted cash flow (DCF model): The model projects future cash inflows and outflows and discounts the cash flows to present value. If a project generates net cash inflows, the company may invest in the project.
  • Mergers & acquisitions (M&A) modeling: Analysts will combine an acquiring company’s financial statements with an acquisition target’s statements. The combined financials reveal total profitability, capital structure, and potential synergies. 
  • Leveraged buyout (LBO) modeling: A 3-statement financial model is created for the target of a leveraged buyout. The model includes additional debt and other changes to the capital structure after the buyout. The analysis determines if the purchase makes financial sense.

Components of the 3-statement model

Here are the three financial statements used to create the model:

Income statement

The income statement is generated using this formula:

Revenue - expenses = net income (loss) 

The income statement is produced for a specific period (month, quarter, etc.), and the matching accounting principle matches revenue earned with expenses incurred to grow revenue.

A multi-step income statement includes additional line items for operating expenses and cost of goods sold (COGS).

Balance sheet

Businesses produce the balance sheet using this formula:

Total assets - total liabilities = equity

The balance sheet is created on a specific date, not for a particular period. Here are the components of the balance sheet:

  • Assets are resources used to generate income and sales. 
  • Liabilities are amounts owed to third parties (vendors, creditors). 
  • Equity is the true value of the business. If the owner sells all assets for cash and uses the cash proceeds to pay off all liabilities, any cash remaining is equity.

Note that the equity section of the balance sheet includes shareholder’s equity and retained earnings.

Cash flow statement

The statement of cash flows details the inflows and outflows of cash and cash equivalents for a specific period. Cash equivalents are securities that earn interest and are easily converted into cash, such as money market securities. The statement includes three categories:

  • Cash flow from operating activities: Inflows and outflows from day-to-day operations, including customer payments, purchasing inventory, and processing payroll.
  • Cash flow from investing activities: When the business buys or sells an asset, the cash inflow or outflow is posted as an investing activity.
  • Cash flow from financing activities: This section includes cash inflows from raising capital by issuing equity or debt and cash outflows when investors are repaid.

The cash inflows and outflows are added to compute the net change in cash. The computation for the statement of cash flows is:

The beginning cash balance plus or minus the net change in cash equals the ending cash balance.

Depreciation and amortization are non-cash transactions that do not impact cash flow. If planning includes a large capital expenditure (CapEx) budget and more spending on property, plant, and equipment (PP&E), the higher depreciation expense does not impact cash.

What is a revolver?

The revolver refers to a revolving credit line, a type of short-term borrowing. As explained below, the 3-statement model determines if the business needs additional cash, using the assumptions in the model and data from historical financial statements.

If cash is needed, the model assumes that money is borrowed from the revolver and that the business incurs interest expense on the loan.

How do the three financial statements link together?

Several factors link the financial statements together. Net income in the income statement increases the equity section of the balance sheet. The ending cash balance in the statement of cash flows is equal to the cash balance in the balance sheet.

How to format and structure a 3-statement model

Building a 3-statement model is challenging because of the amount of data required. A financial analyst follows these best practices to create an accurate model. A modeling course can help you generate the analysis using shortcuts to save time.

  • Combine line items: Minimize the number of line items in each financial statement. For example, use one line item for revenue in the income statement rather than listing the revenue components and the total. Reports with fewer line items are easier to review, and linking data is easier.
  • Use color coding: Use black numbers for historical data and blue for forecast calculations. Different colors make it easier to distinguish between the forecast and historical data.
  • Use a single worksheet model: Use a single worksheet model to simplify the analysis and avoid errors. A multi-worksheet model requires the reader to navigate between spreadsheets, and linking multiple spreadsheets increases the risk of error.

Positive vs. positive/negative financial statement presentation

Use a positive financial statement presentation so that nearly all numbers are positive. This format is easier to read and analyze vs. using both positive and negative numbers. For example, the balance sheet displays assets, liabilities, and equity as positive numbers. 

Laying out assumptions

Group the model’s assumptions close to the financial statement line items. For example, an income statement model might assume sales growth rates of 5% each year and that the cost of goods sold is 38% of revenue.

A single spreadsheet should list the assumptions and the income statement line items using the assumptions. 

What is periodicity in a 3-statement model?

Periodicity refers to the periods used to present the information in the 3-statement model. Businesses can choose annual, quarterly, monthly, or weekly periods. The period you select depends on how the model will be used.

A private equity firm analyzing a startup may prefer a different format than a Wall Street analyst working on a large corporation.

Annual models

A discounted cash flow model uses annual periods because present value calculations are based on years.  Leveraged buyout (LBO) models typically use annual periods based on the purchaser’s investment time horizon.

Quarterly financial models

Most companies generate financial statements every quarter, and SEC-registered businesses must report quarterly.

Equity stock research, financial planning and analysis, credit research, and merger and acquisition models use fiscal quarters. Quarterly results are also annualized.

Monthly financial models

A restructuring requires frequent updates each month to assess business liquidity.

Liquidity measures the ability to generate sufficient current assets (cash, receivables, inventories) to pay all current liabilities. This data is combined to produce quarterly and annual financial statements.

Weekly financial models

The thirteen-week cash flow model (TWCF) is a weekly cash flow forecast produced for an entire quarter. TWCF is used for business restructurings and is required for certain bankruptcy filings.

3-statement modeling best practices

Strive to create a model that fits your business needs and is easy to read and understand. 

Periodicity

Use the discussion above to decide which period is necessary for your model.

Keep in mind that shorter-period results are rolled up into longer periods. Weekly reports are rolled up into monthly, quarterly, and possibly annual reports. This increases the amount of time and effort needed.

Keep assumptions and inputs logically separate from calculations and outputs.

Color code the data in your model and separate assumptions from calculations. Create a format that a reader can review with minimal effort.

Avoid linking files together

Use a single worksheet model to simplify the analysis and avoid errors.

When multiple spreadsheets are linked, the risk of error is higher, and it’s more difficult to review the calculations for accuracy.

Use corkscrew/roll-forward schedules when forecasting balance sheet items

A corkscrew or roll-forward balance sheet connects the prior period balances to the current period. Balance sheet account balances are connected from one period to the next, meaning that the ending cash balance on April 30th is the opening balance for May 1st. 

Income statement accounts do not roll forward.

Income statement balances are adjusted to zero, and the net change in all income statement accounts (revenue and expenses) is net income. When the accounts are adjusted to zero, net income is posted as an increase in equity in the balance sheet. 

Every balance sheet account can be traced from one period to the next in a roll-forward schedule.

Create model plugs for cash and revolving credit lines

The 12 steps to complete a 3-statement financial model are explained below. In step 10, the ending balance in the cash flow statement is used to “fill in” or “plug” the revolver balance in the balance sheet.

Math and other types of analysis often require students to solve for a variable once all other variables in an equation are known. The 3-statement model determines the revolver balance near the end of the analysis.

The revolver refers to a revolving credit line, a type of short-term borrowing. If the model determines that more cash is needed, the revolver balance increases, and the business incurs interest expense. The revolver is only used if funds are required.

Avoid Excel circularity

Excel circularity occurs when a calculation depends on itself to determine an output. Circularity is a risk if the 3-statement model requires a dollar amount for the revolver.

To illustrate, assume that the model determines that $40,000 is needed to operate, and the revolver is increased in the balance sheet by $40,000. This entry changes two other statements:

  • Income statement: Interest paid on the new $40,000 loan increases interest expense.
  • Statement of cash flows: The $40,000 loan is a cash inflow, and cash outflows pay interest on the new loan.

A properly designed 3-statement financial model will automatically adjust the statements for a new revolver balance.

Create rules of cash to guide the cash flow statement

The cash flow statement is created using four rules of money:

An increase in assets generates a cash outflow

A company eventually pays cash for an asset. The business may pay for the asset in cash at the sale or repay a loan using cash over time.

A decrease in assets generates a cash inflow.

When an asset is sold, cash is received immediately after the sale is closed. If the seller allows the buyer to finance the purchase, loan payments increase the seller’s cash balance. 

An increase in liabilities and equity generates a cash inflow

A new loan or issuing common stock to shareholders both produce cash inflows.

A decrease in liabilities and equity generates a cash outflow

Repaying a loan or retiring common stock shares both create a cash outflow.

12 steps to create an integrated 3-statement financial model

Businesses use these 12 steps to build the three financial statements and to determine if additional cash is required from the revolver. If additional funds are needed, interest expense and cash outflows both increase.

1. Enter your historical financial data for the income statement and balance sheet into a spreadsheet platform (e.g., Excel)

You can use prior SEC reports to gather information if the business is registered with the SEC. Use the SEC EDGAR system to search for company data. Firms must file Form 10-Q quarterly and Form 10-K annually, and these reports must include financial statements.

Public and many private businesses issue press releases that explain financial news about the company. Equity analysts follow public companies, and issue research reports that you can access. 3-statement modeling requires multiple years of economic data.

Try using an Excel plugin to input historical data directly into a spreadsheet to avoid manually entering numbers.

2. Calculate key ratios and statistics to understand historical performance and business drivers

The model projects financial performance based on the specific ratios used for an industry. Assumptions about revenue growth and the gross margin are commonly used. Here are four other metrics:

  • Capital expenditures: Capital-intensive businesses make assumptions about capital expenditure growth and how to finance purchases.
  • Churn rate: A SaaS business dependent on subscription revenue will make assumptions about churn rate and customer retention.
  • Accounts receivable turnover ratio measures how quickly a business collects cash from credit sales. The accounts receivable turnover ratio is (net credit sales) / (average accounts receivable). This article explains why the ratio is important.
  • Accounts payable turnover ratio: The AP turnover ratio measures how quickly a business pays its total supplier purchases. The accounts payable turnover ratio is (net credit purchases) / (average accounts payable). You can read more about the ratio in this article.

Select ratios and statistics that you frequently use to monitor business performance.

3. Determine the base assumptions that will drive your forecast

Assumptions are applied to the 3-statement model in a specific order. The steps below explain how the analysis moves from the income statement to the balance sheet and the statement of cash flows.

Assume that you project a 5% increase in sales each year. Selling more generates higher expenses for marketing, sales, and the total cost of products and services. 

More sales drive higher cash inflows from customers, and more net income increases the equity section of the balance sheet. The sales increase has an impact on all three financial statements.

4. Forecast the income statement (excluding interest)

Start building the model using the income statement. Use assumptions regarding sales, prices, and costs to forecast revenue and expenses. Many expenses are forecasted based on a percentage of sales, and a higher sales assumption generates more expenses for the model.     

Complete the income statement model to EBITDA (earnings before interest, taxes, depreciation, and amortization) and move to step 5.

5. Predict long-term capital investments and assets

Make assumptions regarding asset investments, including property, plant, and equipment. Businesses must replace holdings over time or add new assets to expand the business. An increase in fixed asset balances results in higher depreciation expense in the income statement.

Use this formula to forecast fixed asset balances:

Closing balance in the prior period + fixed asset additions - total depreciation = ending balance

Post the depreciation expense to the income statement.

6. Predict financing activity (e.g., debt and equity)

Next, determine if the business needs to raise additional equity or intends to increase borrowings during the analysis period. This calculation is separate from the revolver amount explained below.

Add any new borrowing to the total debt schedule and calculate the increase in interest expense. Use the same analysis for debt repayments and reductions in total interest expense.

7. Complete the income statement

Depreciation expense (step 5) and interest expense (step 6) are posted to the income statement.

8. Forecast the balance sheet (excluding cash and revolver)

Most of the balance sheet accounts are forecasted in this step. Here are some common strategies to forecast the balance sheet:

Working capital ratios

The working capital balance is the current assets (cash, accounts receivable, inventory, etc.) available to pay current liabilities (accounts payable, the current portion of long-term debt). You can use several ratios to forecast working capital balances.

Sales in the income statement impact the change in accounts receivable and inventory. Turnover ratios estimate how quickly the business collects cash from customers and how fast inventory is sold. These ratios are used to project accounts receivable and inventory balances.

The accounts payable turnover ratio measures how quickly a business pays its total supplier purchases. More sales produce more spending, which impacts accounts payable.

Fixed assets and debt

The fixed asset balance (step 5) and the forecast for long-term debt (step 6) are posted on the balance sheet.

The cash and revolver (liability) balances are blank at this point in the analysis. The cash flow statement determines the cash balance and a negative cash forecast requires the business to borrow using the revolver.

9. Forecast the cash flow statement using the rules of cash

Create the cash flow statement using the income statement, balance sheet, and cash rules explained earlier. Determine the change in each balance sheet account from the prior year to the current year. Here are two examples using the rules of money:

An increase in assets generates a cash outflow

The inventory balance increased by $40,000 from the prior year. The asset account increase is recorded as a cash outflow in the statement of cash flows.

An increase in liabilities and equity generates a cash inflow

The company receives $100,000 by issuing new shares of common stock. The increase in equity is posted as a cash inflow in the statement of cash flows.

Each cash flow is posted as an operating, financing, or investing activity. Most cash flow statements use the indirect method to determine cash flow for operating activities.

Using the indirect method for operating activities

The indirect method starts with net income and ends with cash flow from operating activities. Here’s an example:

Details Amount
Net income $100,000
Add: Depreciation expense $20,000
Change in accounts receivable ($10,000)
Change in inventory $20,000
Change in accounts payable ($8,000)
Cash flow from operating activities $122,000

Depreciation expense is a non-cash item, and the balance is added back to the cash flow analysis. Accounts receivable, inventory, and accounts payable are all day-to-day operating activities. The rules of cash determine the dollar amounts in the cash flow statement.

Financing and investing activities use the direct method to post cash inflows and outflows. Here is a completed cash flow statement: 

Details Amount
Cash flow from operating activities $122,000
Cash flow from investing activities ($50,000)
Cash flow from financing activities ($60,000)
At the beginning of year, the cash balance $30,000
Change in cash $12,000
End-of-year cash balance $42,000

The change in cash is the sum of the three cash flow activities ($12,000). The $42,000 ending cash balance is posted on the balance sheet.

10. Balance the balance sheet and fill in the revolver using the ending cash balance from the cash flow statement 

If the ending cash balance projection for a particular year is negative, the model assumes that the business will borrow funds from the revolver. The model also assumes that the revolver loan balance is fully repaid in future years when positive cash flows are available.

To illustrate, assume that the ending cash balance projection in 2025 is ($70,000). To ensure that the business has enough cash to operate, the model borrows $70,000 from the revolver. Cash (asset account) and revolver (liability account) increased by $70,000.

11. Build the interest calculations

The business must pay interest expense on the new loan. At a 6% interest rate, annual interest on the $70,000 loan is $4,200. Interest expense is posted to the income statement.

12. Link interest into the income statement and deal with circular references

The revolver and the loan interest change the balance sheet (step 10) and the income statement (step 11). The revolver loan is also a cash inflow, and the interest expense is a cash outflow in the cash flow statement.

When you post the revolver activity, check the spreadsheet and remove any circular references. The result should be three financial statements properly linked with the revolver loan’s impact.

Check your 3-statement financial model before sharing it with colleagues

The 3-statement model is complex and should be carefully reviewed before distribution. Use these best practices to verify that the model provides useful information.

Does the output look reasonable, given your base assumptions?

Take a step back and consider if the output is reasonable based on your assumptions. To explain, consider the relationship between sales, accounts receivable, and cash inflows.

A company that projects rapidly increasing sales may also see an increase in accounts receivable over time. The cash inflows from operations increase as sales increase and customers pay on receivable balances. Review the relationship between account balances.

Is the formatting consistent?

Verify that the formatting is consistent. Use the same colors for numbers and keep headers and footers consistent. Each financial statement and supporting schedule must use the same column widths.

Is the layout intuitive and easy to read?

Readers should be able to identify both historical data and projections easily. Make the layout intuitive by positioning data to make it easy to read. For example, supporting schedules are labeled and placed below the financial statements.

Are complex calculations broken into steps?

Think carefully about how much data the reader needs to understand a calculation. Explain the revolver balance and the interest calculations in a separate schedule. 

Is the circular switch on? Are iterations on?

If the model requires a revolver loan, all three financial statements change, and the model may have circular references. Use the options menu for formulas in Excel so that the software displays circular references and the specific cells that are affected. This Excel tool helps you make corrections.

Using the 3-statement model for financial analysis

The 3-statement model can be used for several types of analysis:

Scenario analysis with the 3-statement model

Once the 3-statement model is set up, the assumptions can be changed to fit different scenarios. 

Managers often plan using best-case scenarios, worst-case scenarios, and other assumptions. For example, the best-case sales forecast is a 12% increase over the next year, and the worst-case is a 5% decline. These scenarios can be run through the model to assess the financial impact.

Sensitivity analysis with the 3-statement model

Sensitivity analysis provides different scenarios, and the user can evaluate how the model’s output changes for each scenario. 

Take discounted cash flows as an example. One scenario discounts cash flows at 5%, and the second scenario uses 8% for discounted cash flows. The user can toggle between the scenarios to assess the impact of the discount rate.

Wrap-Up: Putting the 3-statement financial model into action

The 3-statement financial model helps you make informed forecasting, cash management, and financing decisions.

Successfully generating these models necessitates clean data; however, finance teams often spend hours reconciling financial data like credit card transactions and bank statements to successful generate all three statements, taking away time from strategy.

Want to learn how Rho can help you automate accounting reconciliation and generate accurate financial statements in less time? Sign up to receive a demo today.

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