Introduction-

A 3 Statement financial model is a basic financial tool combining all the financial statements of a company, such as the income statement, balance sheet, and cash flow statement into an easily readable and documented framework. This model gives an integrated view of the financial health of a company. These statement models are essential to most of the business functions that require decision-making processes, analysis of the company, and strategic financial planning for the operations of the business. In this blog, we are going to look at some of the major concepts related to this specific financial model, its components, steps for building the model, and its applications in the real world.

​​Basic Concepts-

• The 3 statement financial model is created to reflect the connection among the financial statements of a company. It helps the financial analyst and other professionals in finance to predict the future performance of a company, gain a better understanding of past trends, and gain useful insights to help make important business decisions.
• It is a well-integrated financial model which, in the main use companies require in order to predict statements such as balance sheet, income statement, and cash flow statement. These benefit from projecting financial performance forward-looking. It may also be generated by recording all the financial data then subsequently analyzed with the help of the historical outcomes involved in business operations.

Significance of 3 Statement Financial Model in the Industry-

It also has many applications such as valuation, scenario analysis, and the decision-making process. It enables financial analysts to determine the value of the firm by using the discounted cash flow (DCF) approach. The model can also be used to simulate different business scenarios to determine how changes in speculations will affect the firm’s outcomes. Businesses can make informed strategic decisions about budgeting, investments, and resource allocation.

• Overall view: This financial model can provide a holistic view of the company’s entire operations, liquidity ratios, and profitability levels. It is achieved by bringing together the three important statements of the company.
• Dynamic Forecasts: This model offers several dynamic forecasts. That means the alterations that occurred in one statement automatically affect the other one. This particular feature will reveal the company’s actual financial situation.

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• Financial Modeling and Valuation

This financial model is used by most investors and stakeholders to determine the financial health and stability of the company. They also utilize this model to analyze potential financial risks and make informed investment decisions for the company.

Key Elements of a 3 Statement Financial Model-

This financial model is explained briefly as under with the key components involved in this type of model. It will be easier to prepare the statements and analyze this model if the understanding and knowledge of these components are properly understood. The three major financial statements that are involved in this financial model are – the Income Statement, the Cash Flow Statement, and the Balance Sheet.

• Income statement – An income statement is a very handy financial report used in every type of business. It summarizes the whole revenue, expenses, losses, and profits of the company for a given period. It provides insights into operating performance and profitability. It is also termed Earning Statement or Profit and Loss (P&L) Statement in certain business environments. It will reveal the income earned by a company for a particular period of time. The major elements incorporated in the income statement are:

Revenue or Sales is the gross amount which is produced due to normal business activities

Cost of Goods Sold (COGS) is direct costs which are involved in production of goods and services. It includes materials and labor.

Gross Profit = Total value of revenue minus the value of COGS

Operating Expenses = Costs added to support running the regular operations of the business such as administrative expenses, selling expenses, etc.

Operating Income = Gross Profit minus the value of Operating Expenses.

Other Income and Expenses comprise the non-operating incomes and expenses of the company such as interest expense, interest income, and other forms of gains or losses realized in selling the business assets

Income Before Tax comprises operating income plus or minus other income and expenses

Income Tax Expense is the amount of taxes the company is supposed to pay as determined by the taxable income range.

Net Income or Bottom Line is the final profit value after all expenses and even taxes.

• Balance Sheet – A balance sheet will provide a picture of the company’s liabilities, assets, and equity at a specific point in time. It helps the business stakeholders to assess the financial stability and health of the business. The major components are assets (current assets, non-current assets), equity (common stock, additional paid-in capital money, and retained earnings), and liabilities (current liabilities and non-current liabilities). Financial money lenders use the balance sheet to assess the company’s capability to repay the taken loans.

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• Asset Based Valuation
• Cash Flow Statement – A cash flow statement provides a detailed study of the company’s cash inflows and outflows over a specific period. It is typically split into three main divisions: operating activities, financing activities, and investing activities. It helps to evaluate the company’s capability to make cash to fulfill its financial responsibilities. Also, it can provide an understanding of how nicely a company manages its money for its day-to-day functions. Investors use the cash flow statement to measure the financial health and sustainability ratios of the company.

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• Cash Flow Analysis

Building A 3 Statement Financial Model-

Making this financial model implicates several measures. Let’s explore the procedure involved in detail:

Step 1: Gather the Historical Financial Data

You can start the process by collecting historical financial data. It should be from at least three to five years back. This data will become the foundation for your financial points. Different sources may include company financial reports, industry reports, and market research.

Step 2: Develop the Income Statement for the company

Structure of the Income Statement. The income statement generally includes Revenue, Cost of Goods Sold (COGS), Gross Profit, Operating Expenses, Operating Income, Other Income/Expenses, and Net Income.

Now forecast the total revenue of your business. Earnings can be predicted using diverse methods like Past business Growth Rates, Current market analysis, and business deal funnel. 

Now, estimate the expenses. Expenses can be launched as fixed or variable ones. The Fixed Expenses are the costs that stay constant such as the business location’s rent and employees’ salaries. The Variable Expenses are the costs that keep changing with the company’s sales like production costs of the products or services offered by the company.

Step 3: Construct the Balance Sheet for the company

The balance sheet will have three primary sections. The assets are the resources possessed by the company. It includes the current assets like cash or inventory and non-current assets like property or equipment. The liabilities are the financial responsibilities owed by the company. It includes current liabilities like accounts payable or short-term debts and long-term liabilities like payable bonds or long-term loans. The equity is the remaining interest in the assets after the company’s liabilities. It includes common stock and retained earnings of the company.

Now is the process of linking it to the income statement. The total income generated from the company’s income statement cash flows into the enclosed earnings segment of the balance sheet. The next phase is forecasting the company’s assets and liabilities. The assets make use of the percentage of sales processed or the aging procedure for both the accounts receivable and inventory of the company.  The liabilities are similar to that of assets and other projects related to the company’s sales or other particular operational requirements.

Step 4: Create the Cash Flow Statement for the company

Next, specify the structure of the cash flow statement of the company. The cash flow statement is separated into three areas. The operating activities are the money that is generated from major business processes. The investing activities are the cash amount that is used for business investments in long-term company assets. The financing activities involve the cash obtained from or spent on exterior financing resources.

Now, focus on the direct method and non-direct method. The direct method provides a list of the cash inflows and outflows directly in and out of the business. The indirect method of processing starts with total earnings and alters for non-money commodities and modifies in the company’s working capital.

Now you can link these to other financial statements of the company. The total cash earnings from the company’s operating activities should connect with its net revenue from the income account. Any type of modifications in the company’s balance sheet entries like the accounts receivable and inventory entries will also impact the cash flow information.

Step 5: Make the Financial Model in Excel Sheet

MS Excel is the most familiar tool for creating a 3 statement financial model for businesses. Some of the key actions include creating a worksheet, input of past data, building formulas, and generating business scenarios. 

Step 6: Conduct the business Scenario and Sensitivity Analysis on these data

Once your financial model is created, you can conduct several business scenario analyses to assess how various financial variables are affecting the entire financial outcomes of the company. Some of the major areas to test in this analysis are the company’s sales growth rates, changes in the costs involved, and major types of financing business decisions. 

The Effective Practices For A 3 Statement Financial Model-

Some of the effective and best practices that can be applied to the company’s financial statements and the building process of the financial model are explained in the below section. This will ensure that you can build an effective financial model for your company. 

• Always try to keep the entire financial model simple. While it is generally more attractive to include several items like complex financial formulas in your model, always keep in mind that better clarity is much more appealing and understandable. Make use of straightforward financial formulas and clear document layouts.
• The document assumptions are another area where you can improvise your financial model-building procedure.  Always note that your financial assumptions such as the company’s growth rates and cost calculations are taken to provide meaning for your financial projections.
• Make use of consistent formatting in your financial model. Your financial statements must maintain a uniform style for its font, colors, and letter sizes. It will enable easy reading for those in the audience.
• It is always important to regularly update your financial model. The financial models should be always dynamic in character. You must regularly modernize and update the financial model with several actual business performance financial data and adjust its forecasts accordingly.
• The last tip that we are going to discuss here is to test your model. It is important that before fully depending and trusting on your financial model, you can conduct tests to ensure that the performed calculations are accurate and logical.

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• Types of Financial Models for Business Analysis

Applications of the 3 Statement Financial Model In the Industry-

• Analysis of Investments

Investors use this type of financial model to calculate potential investments by considering the company’s profitability level, liquidity ratios, and cash flow within the business. It will help them in making informed decisions about buying and selling the stocks of the target company.

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• Investment Banking

• Corporate Finance

Companies make use of this particular financial model for interior business planning and decision-making processes. It includes activities such as business budgeting, forecasting financial performance, and strategic business planning. It also helps the company management to understand the financial importance of changes in the company’s operations.

• Mergers and Acquisitions Transactions

In the case of merger and acquisition business scenarios, a complete 3 statement financial model can allow most companies to evaluate the target company’s financial health, and stability, predict its future performance after the process of acquisition, and negotiate relevant conditions and terms based on different financial forecasts.

Final Thoughts-

A 3 statement financial model is an indispensable means for anyone who is involved in activities like investment, financial analysis, and corporate strategy. If you have a proper understanding of how to create and make use of this financial model effectively, then you can get valuable insights into the financial performance of the company and make corresponding informed decisions. No matter whether you are a financial investor who is looking to assess potential investment opportunities or a corporate manager who is planning to strategize future performance, a clear dominance of this financial model will improve your financial benefits and analytical proficiency.

In today’s evolving business environment, the capability to forecast, examine, and modify is essential. A well-constructed financial model will be able to provide better clarity and flexibility that is required to steer several financial challenges in the business world. As you continue to grow your financial modeling skillfulness, recognize that continuous training and improvement will lead to a great level of accuracy.

FAQs-

1. What are the three financial statements included in the 3 Statement financial model?

This financial model combines three statements involved in a business – the income statement, balance sheet, and cash flow statement. The income statement describes the revenues, expenses, and profits of a company over a particular period. The balance sheet delivers a picture of the company’s assets, liabilities, and equity at a specific point in time. The cash flow statement follows the inflows and outflows of cash which helps to reflect how money is made and utilized in various business operations, investing purposes, and financing activities of the company.

2. Why is it important to link the financial statements together?

The process of connecting these statements will provide a complete view of the financial health of a company. Any sort of changes done in one statement will directly affect all the other statements. For example, the total revenue from the income statement provides controlled earnings on the balance sheet, and cash from business operations will affect the entries of the cash flow statement. This connectivity helps in comprehending how various operational business decisions will impact the entire financial performance of the company.

3. How can I build a 3 Statement financial model?

To build this type of financial model, you can start by gathering all the available historical financial data of the company. Now, you can create the income statement first by specifying the entries like the company’s total revenues and expenses based on documented past trends. In the next stage, develop the balance sheet of the company by assessing its future assets, liabilities numbers, and equity based on the company’s income predictions. Finally, create the cash flow statement by connecting it to both the other statements – income statement and balance sheet to contemplate the company’s cash activities accurately. You can make use of several tools like Excel for this building process.

4. What are the common uses of a financial model?

This type of financial model is used for various purposes in the business world. The uses include corporate budgeting, financial forecasting, investment analysis, and valuation of the target company. It will also help financial analysts assess the financial viability of the company, conduct various scenario analyses, and make informed strategic decisions on different business activities such as mergers and acquisitions. Investors also depend highly on this financial model to evaluate their potential investments and their profitability returns.

5. What are the best practices for creating an effective financial model?

Some of the major best practices that are used in the creation of an efficient financial model include keeping the financial model simple and clear, documenting different types of assumptions that are made during financial projections, and using consistent formatting for enhanced levels of readability. You must also perform regular updates with actual business performance data. It is essential for maintaining the financial accuracy of this model. Additionally, running sensitivity analyses will also help to assess how differences in key financial speculations will affect its whole outcome and enable providing a better strategic decision-making procedure.