3-statement model is a foundation of financial analysis and modelling within an organization.
It combines the income statement, balance sheet, and cash flow statement into one live and linked model.
This guide will introduce you to what a 3-statement model is, how it is built, and how it is used.
What is a 3-Statement Model?
Multiple attributes that are associated with 3-statement model includes that it is a financial model that contains financial forecast of a company.
With the inputs from the income statement, balance sheet and cash flow statement this model offer an overall view of an organization’s financial status.
There are Many types of financial statement, but three key financial statements that every business should prepare are:
- Income Statement: Report revenue and cost for any given period of time to showcase the business’ ability to bring in an income or a profit.
- Balance Sheet: The accounting statement that reports on the position of a company’s assets and liabilities at a given date as well as equity.
- Cash Flow Statement: This statement gives the actual cash flow for a period, detailing operating, investing and financing activities.
This article seeks to underline the need for a 3-Statement Model.
- Integrated View: Gives a rather vivid view of the economic situation of a company.
- Forecasting and Decision-Making: Is useful in arriving at strategic decisions that are informed by future income or expenditure.
- Investment Analysis: This gives information on profitability, liquidity and solvency to investors.
- Scenario Planning: Beneficial in assessing the outcome of implementing of various tactics or some market situations.
How to create a 3 Statement Model ?
Step 1: Input Historical Data
- Step one is entering historical financial data for at least 3-5 years or more depending on the business type. Such data consist of revenue, expense, asset, liability, equity, and cash flow.
Step 2: Set Up the Income Statement
- Start with prior period sales expectation critical to developing revenue forecast from past performance and prospects of a market.
- COGS to determine gross profit Operating expenses to establish operating income.
- Accompany depreciation, interest and tax charges.
Step 3: Construct the Balance Sheet
- Connection of net income to retained earnings that form part of the income statement.
- Estimate of total assets, total liabilities and total stockholders’ equity utilizing historical percentage relationships and other presumptions.
- Make certain total assets equals the sum of liabilities plus the value of equity.
Step 4: Build the Cash Flow Statement
- First is the net income followed by additions and subtractions of non-cash sources of revenue such as depreciation.
- The relationship between links in working capital change and changes in capital expenditure.
- Report other financing activities such as, borrowing or issuing of bonds or paying dividends.
Step 5: Link the Statements
- link the three financial statements by developing formulas.
- Make sure that the cash flow statement has got a reasonable figure in the ending cash that should match with the balance sheet regarding cash balance.
- Ensure that retained earning balance with net income and the dividends paid.
Key Components and Key Assumptions
Revenue Drivers
- Historical growth rates
- Market trends
- Company’s strategic initiatives
Expense Assumptions
- Fixed vs. variable costs
- Organizations’ profits and operational gains
Working Capital Assumptions
- Day’s sales outstanding (DSO)
- Days Payables Outstanding (or DPO)
- Inventory turnover ratios
Capital Expenditures (Capex)
- Historical trends and line investment proposals
Financing Activities
- Debt schedules
- Dividend policies
Application of the 3-statement model
Financial Forecasting
- Forecast future income statement, balance sheet and computerized statement based on changes in revenues, expenses and investment.
Valuation Analysis
- Another way is to use the model for discounted cash flow valuation where free cash flows are forecasted.
Stress Testing
- Determine the level of risk inherent in fluctuation in market environment or a change in management’s business tactics and plans.
Investor Presentations
- Assist investment decisions by producing informative reports and different models based on selected financial flows.
Some problems that people face when constructing the model
Data Quality
- They also state that using historical data can be imprecise due to use of either inconsistent or incomplete data.
Complexity
- When connecting the three statements stakeholders are supposed to pay attention to details and formula.
Assumption Bias
- It becomes impossible to achieve unrealistic goals if the foundation of the strategy is set on overly optimistic or pessimistic pointers.
Scenario Analysis
- Developing models that can facilitate a number of potential outcomes means that the process can be very time consuming.
Guidelines on Building a 3-Statement Model
Use Consistent Formatting
- For I/O plausibility, it is always recommended to label all inputs, calculations, and outputs as clearly as possible.
- It is recommended to use color codes to differentiate between the plain values which have been coded and formulas to the end user.
Validate the Model
- Balance sheet accounts and cash flow statements must be reconciled.
- Understand key assumptions used for stress testing to validate our findings.
Keep It Flexible
- Use drops down boxes or tabs for scenario analysis.
- Use dynamic for the formula of scalability.
Document Assumptions
- When including key assumptions be sure to label these clearly and to state from where they come from.
Example of a 3-Statement Model
Let’s for instance have a retail company intending to predict its balance sheet for the next five years. The process involves:
- Forecasting of revenues using past sales, market conditions and growth relations.
- Determining cost of sales by costing of the devices and estimating other operating expenses for net income calculation.
- Net income and retained earnings: its relation in the balance sheet.
- That leads to an adjusting of the same in the cash flow statement.
The integrated model reveals:
- Anticipated annual growth of revenues at 10% per year
- Bettering of the company’s profit-making capability through cost control
- Availability of cash to finance the expansion agenda
Conclusion
The 3-statement model is an essential model to which every financial professional should be familiar with.
It synthesizes the income statement, balance sheet and the cash flow statement and affords one a holistic view of the financial position of a business entity, enhance strategic planning additional for communication of the result to the relevant stakeholders.
It is, therefore, essential to make accurate model assumptions, and ensure that the model undergoes verification constantly.
Frequently Asked Questions
1.What is the purpose of linking the three financial statements in a model?
Linking means that changes to one statement will change the others, so that their interdependencies are actually reflected.
2. How do market conditions affect a 3-statement model?
External factors affect assumptions such as revenue growth rates, interest expenses, or cost structures, and then cascade throughout the model.
3. Could the 3-statement model be applied to non-profit organizations?
Yes, but changes are necessary, including pay attention to fund accounting and removing profit-related metrics like net income.
4. How is the working capital accounted for in a 3-statement model?
Current assets and current liabilities are taken to calculate work capital. Such changes are represented in the cash flow statement which shows the implications of operational cash flow.
5. What tools or software are commonly used in building a 3-statement model?
The most common are Microsoft Excel, Google Sheets, and other high-level financial modeling packages such as Wall Street Prep, or Macabacus.
6. What should you do with non-operational items in the 3-statement model?
Items such as extraordinary gains or losses are adjusted in the Income Statement with proper links to the Cash Flow Statement.
7. What are some difficulties involved in using a 3-statement model to make a forecast?
Challenges include an accurate prediction of future assumptions, macroeconomic uncertainty handling, and the steady update of the model.
8. What is a sensitivity analysis, and how is it included in the model?
Sensitivity analysis tests how changes in key assumptions affect outcomes-for example, changes in revenue growth or interest rates.
It often takes the form of scenario modeling.
9. What are common mistakes when building a 3-statement model?
There are incorrect linkages between statements, unrealistic assumptions, inconsistent format, and circular references that have been ignored.