3 Statement Financial Model – Importance, And Meaning Explained
Financial statement analysis (or simply financial analysis) is the act of studying and analyzing a company’s financial accounts to make better economic decisions that will generate money in the future. A 3-statement financial model (also known as an integrated financial statement model) is used to forecast or project a company’s overall financial status. It includes three types of financial statements that are connected: the balance sheet, income statement, and cash flow statement. As a result, if one financial statement changes, the other financial statements should be adjusted proportionately. These financial statements should be interconnected in terms of financial modeling.
The goal of financial statements is to give information about an enterprise’s financial situation, performance, and changes in financial status that is relevant to a wide variety of users when making economic choices. Financial statements must be easy to understand, and should also be relevant, dependable, and comparative. The financial condition of an organization is directly tied to its reported assets, liabilities, equity, revenue, and costs. Readers who have not previously read financial statements are expected to comprehend them “decent understanding of business and economic operations, as well as accounting, and who are eager to examine the material.
It is utilised by a wide range of stakeholders, including credit and equity investors, the government, the general public, and organisational decision-makers. These stakeholders have various interests and use a range of ways to satisfy their demands. For example, stock investors are concerned about the organization’s long-term earnings capacity, as well as the sustainability and growth of dividend payments. Creditors seek to guarantee that the interest and principal on the organization’s debt securities (such as bonds) are paid on time.
Individuals asking for a personal loan or financial help may be asked to provide personal financial statements. A personal financial statement is often comprised of a single form for reporting personally owned assets and liabilities (debts), as well as personal sources of income and spending, or both. The entity providing the loan or help determines the form that must be completed.
Build a 3-Statement Financial Model
Enter Historical Data into Excel
In this stage, we download, type, or paste the company’s historical financial information into Excel. Once you’ve entered the data into Excel, you’ll need to apply some basic formatting to make it easier to understand and follow the structure you want your model to take. The historical information is inputted in a blue font colour beneath the historical periods, as shown in the picture below.
Choosing the Assumptions That Will Power the Prediction
With the historical financial data in Excel and an easy-to-use format, we can begin calculating basic measures to analyze the company’s previous performance. Revenue growth, margins, capital expenditures, and working capital terms must all be calculated (such as accounts payable, inventory, and accounts receivable). The assumptions portion, which drives the prediction, is seen below.
Income Statement Forecasting
Now that the assumptions have been established, it is time to begin predicting the income statement, beginning with sales and working down to EBITDA (Earnings Before Interest Taxes Depreciation, and Amortization). At that point, we’ll need to create support schedules for things like capital assets and finance activities.
Estimating Capital Assets
Before we can finalize the income statement in the model, we must anticipate capital assets such as Property, Plant, and Equipment PP&E. To achieve this, we take the closing balance from the previous quarter, add any capital expenditures, subtract depreciation, and arrive at the closing balance. Depreciation may be estimated in several methods, including straight line, falling balance, and percentage of income.
Financing Activity Forecasting
Following that, we must create a debt schedule to calculate interest expenditure on the income statement. Similarly, to the preceding section, we take the previous period’s closing balance and add any gains or reductions in principle to arrive at the closing balance.
The interest expenditure can be estimated based on the initial balance, closing amount, or average debt outstanding balance. Alternatively, if one is available, a thorough interest payment schedule might be followed.
Balance Sheet Forecasting
Except for the cash balance, which will be the final step, it is easy to complete the balance sheet in our three-statement model at this point. Working capital components are projected based on average days payable and receivable, as well as inventory turns. Capital assets (PP&E, for example) and debt balances are derived from the above schedule.
Finishing the Cash Flow Statement
With the balance sheet (save for cash) finished, we can create the cash flow statement and finish our three-statement model in Excel. This part is largely finished by just connecting to things that have already been computed in the model above. Each of the three major components must be completed: cash from operations, cash from investment, and cash from borrowing.
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Planning for Growth with 3-Statement Financial Models
After developing a 3-Statement Financial Model, a corporation may use the information contained inside it to develop numerous budgets. This will enable them to model different scenarios and analyse several 3-Way Forecasts to plan for a wide range of possible outcomes. This not only benefits development planning but also avoids scenarios that may derail the company’s course.
There are several advantages to performing scenario analysis with a 3-Statement Financial Model. Gaining the capacity to prepare for the future, becoming proactive, minimizing risk and failure, and estimating returns and losses are just a few examples. However, doing scenario analysis involves a great level of competence, and one cannot forecast or model every possible event. However, by modelling the best-case, worst-case, and base-case scenarios, one may acquire useful information for driving business decisions.
Financial predictions are critical for any organisation, regardless of size. In recent years, the 3-Way Forecast, also known as the 3-Statement Financial Model, has become indispensable. Our free Forecasting Fundamentals Guide will walk you through the fundamentals of financial forecasting and its application in business.
Developing a 3-Statement Financial model
When selecting to create a 3-Statement Financial Model, you must first decide which era you will model for. The goal of your model will dictate whether this is done annually, quarterly, monthly, or weekly.
When attempting to use the model to generate DCF model valuations, this timeframe is frequent. This is because a terminal value requires at least 5 years of projections. LBO models are frequently yearly. A DCF model, which stands for Discounted Cash Flow, is a projection of a company’s free cash flow that has been discounted back to today’s value. A leveraged buyout model is an appraisal of a transaction in which someone buys a firm nearly completely using debt.
A quarterly period is commonly used for a variety of reasons and is sometimes wrapped up into a yearly accumulation. These objectives might include:
- Credit for equity study
- Financial analysis and planning
- Mergers and acquisitions, among other things
When considering restructuring and project finance, this sort of term is frequent. Anywhere where monthly liquidity tracking is essential. These frequently accumulate into a quarterly accumulation.
The “13-week cash flow model” is the most commonly used weekly model (or TWCF). The bankruptcy procedure must keep track of cash and liquidity. The most prevalent cause for a weekly model is bankruptcy.
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An Excellent 3-statement Financial Model’s Architecture and Structure
There are two common methods for developing a 3-Statement Financial Model. There is single- and multi-worksheet layouts. You may prefer one over the other depending on your demands and company structure. However, if feasible, we advocate a single-worksheet style since it is easier to traverse and reduces the possibility of calculation mistakes.
If you intend to create your complicated financial model, you should follow a consistent set of best practices. This will simplify and improve the transparency of modelling and auditing tasks.
Basic Three-statement Formula Best Practices for Model Formatting
Colour coding inputs, formulae, outputs, and so on can help you browse your document more quickly. While the typical colours are blue, black, and red, we won’t criticise if you choose a different colour scheme.
Maintain consistency in format throughout. This might include maintaining a consistent unit scale, standard decimal placements, and so forth.
Keeping Hard Numbers to a Minimum
Avoid using partial inputs that mix cell references and hard numbers.
Although it may appear easy, standardising your column width and using consistent header labels may make a big impact.
Following a Rigorous Framework
When models grow in size, you should maintain a rigid framework.
As an example:
When predicting the balance sheet, use roll-forward schedules. Separate inputs from computations and outputs in one worksheet (or area of the model).
Avoid connecting files.
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Using the 3-Statement Financial Model to Automate
While many people still use traditional methods to create a 3-Statement Financial Model, there are several advantages to automating this report using specialised solutions.
It is possible to save a significant amount of time by switching from a manual to an automated operation. Removing a particularly hefty portion of the task might free up vital resources for the company’s strategic development.
Automation allows for greater accuracy, allowing any flaws to be detected, analysed, and rectified more readily. It helps ensure that all relevant data sources are used to make the forecast and that mistakes are kept to a minimum.
By automating the procedure, the chance of human mistakes is considerably reduced. This contributes to the forecast’s dependability.
Horizontal & Vertical Financial Statement Analysis
Horizontal analysis analyses financial data over time, usually from previous quarters or years. Horizontal analysis compares financial data from previous statements, such as the income statement. When comparing this previous data, check for variations such as higher or lower profits.
A vertical examination of financial statements is a percentage analysis. Each financial statement line item is given as a percentage of another line item. On an income statement, for example, each line item will be listed as a percentage of gross sales. This method is also known as normalising or common sizing.
Practising 3-Statement Financial Model
Accounting helps us to manage and understand a firm by using past data, which we can then use to make evidence-based decisions on how to proceed. Then, by building on those financial statements by developing a financial model, you can explore how your company might perform in the future based on a variety of factors and assumptions, which will further inform your decision-making process by assisting you in seeing how you can tweak and change your business to achieve the most desirable outcomes.
This tinkering with the model to estimate future results is accomplished through scenario analysis and sensitivity analysis, as discussed in further detail below.
As previously stated, one of the primary advantages of developing a 3-statement financial model is the ability to foresee how changes to operations, finances, and internal investments affect the broad picture of your firm. These changes might range from recruiting another salesman to our bottom line to the look of profitability during a recession?”
Typically, while assessing scenarios, you will begin with a base case scenario, which is your average scenario or the current scenario of your organisation with all variables held constant. Then you may compare the worst-case (worst-case) and best-case situations (the ideal outcome).
Perform Scenario Testing
Scenario planning has multiple advantages and may be utilised to assist various stakeholders in your organisation. You may use it internally to assess how much your firm would scale if you purchased another manufacturing machine, whereas an investor could use it to analyse their prospective profits under various investment situations.
Overall, we believe scenario planning is a valuable technique for getting to know your organisation better. The better you understand what may go wrong and what can go well, the more efficiently and proactively you can plan for any eventuality.
Sensitivity analysis, which is similar to scenario planning but a bit more sophisticated, focuses on a single output to examine how changes to only one or two inputs (rather than a complete scenario’s worth of inputs) affect that single outcome. Scenario planning and sensitivity analysis are frequently used in tandem to improve model users’ comprehension of probable outcomes.
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Relations Between the 3-Statement Financial Model
As you might expect, constructing a three-statement financial projection necessitates a large amount of data and several assumptions.
Profit and Loss Statement
Revenue and cost-of-goods-sold forecasting: For revenue forecasting, this might contain everything from the number of contracts completed to the number of items and subscriptions sold, as well as the price of those products/subscriptions, to the Cost of Goods Sold (COGS – the cost to supply your product/service).
OPEX forecasting: Furthermore, operating expenses (OPEX) such as employee pay, research, and development (R&D), or sales and marketing (S&M) costs. All of these assumptions influence your net income (bottom line), which is shown on your balance sheet.
Opening Balances: Any financial forecast worth it must begin with an understanding of the assets, liabilities, and shareholder equity. Opening balances are critical inputs for a strong financial model to perform properly.
Forecasting Assets: A good model should also be able to anticipate your assets, such as accounts receivable (AR) or your capital expenditure (CAPEX) plan, that is, what you want to own in the future.
Forecasting Liabilities: To whom do you owe money, and when will it become due? Are you planning to finance your business using debt? I believe you’ll agree that recognising your responsibilities is critical to preventing unpleasant shocks that can deplete your financial reserves. This might include everything from credit lines to term loans and convertible notes.
Forecasting Equity: Do you plan to obtain funds through equity from internal or external sources? If so, don’t forget to include this critical component in your financial projection.
Cash Flow Statement
Forecasting Cash Flow: For those who already know, congratulations; for those who don’t, this is a tricky part. A cash flow statement does not require any assumptions! This may appear strange, but keep in mind that the cash flow statement is fully determined by what happens on the income and balance sheets. This is why the balance sheet is so critical in any forecasting process; without it, you are not only presenting an erroneous financial picture but also projecting cash flow incorrectly.
The Big Picture
All three accounting statements are essential for a complete understanding and analysis of a company’s performance from several viewpoints. The income statement provides extensive information about the company’s primary business operations that generate profits. The balance sheet and cash flow statement, on the other hand, place more focus on the management of the firm’s capital in terms of assets and structure.
Top-performing companies will excel in areas such as capital structuring, asset management, and operational efficiency. The interdependence of these three levers is what makes financial statement reporting so important since management is held accountable for controlling them in a way that benefits shareholders.
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Additional Notes on the 3-Statement Financial Model
Notes are items added after financial statements that assist in clarifying items in the statements and give a more in-depth view of a company’s financial position (or “notes to financial statements”).
Notes to financial statements may provide information on debt, accounts, contingent liabilities, ongoing concern criteria, or contextual information that explains the financial data. Individual statement line items are clarified in the notes. Notes are also used to clarify the accounting processes used to compile the statements, as well as to provide values for how certain accounts were computed.
All subsidiaries are disclosed in consolidated financial statements, as well as the degree of ownership (controlling interest) that the parent company has in the subsidiaries.
Any items in the financial statements that are valued by estimates are included in the notes if there is a significant discrepancy between the amount previously reported and the actual outcome. The impact of the variations between the estimated and actual results should be fully disclosed.
Frequently Asked Questions
Q1. What is the worth of developing integrated financial statements?
An integrated model is useful because it allows the user to change an assumption in one part of the model and see how that change impacts all other parts of the model equally and accurately.
Q2. What is the significance of financial statements?
Financial statements provide a high-level summary of a company’s financial condition, including information on operations, profitability, and cash flow. Financial statements are essential since they provide information about a company’s income, expenses, profitability, and debt.
Q3. What are the uses of financial statements?
The primary objective of financial statements is to provide information about an organization’s financial condition, operating results, and cash flows. Data is used by viewers of financial reports to make judgments regarding resource allocation.
To anticipate or project the financial situation of an entire firm, a three-statement model or an integrated financial model is employed. It consists of three interrelated financial statements: cash flow statement, income statement, and balance sheet. The model connects three essential financial statements, including the income, balance sheet, and cash flow statement, to form a unified, dynamically integrated financial model that serves as the foundation for more complicated financial models, such as leverage buyouts and discounted cash.
Financial modeling represents a company’s operations in the past, present, and predicted future in numbers. Company executives may use them to forecast the costs and revenues of a proposed new project. Financial modelling is important for a variety of reasons, but it is especially important for mergers and acquisitions, capital raising, business planning and management, and investment decisions.
There are several advantages to establishing a financial model as a business. Because you can assess whether you can transform your ideas into a long-lasting operational business by measuring (and then evaluating) your business strategy, business model, assumptions, and vision. I hope you found this essay useful. Good luck with your reading.
3-Statement Financial Models serve as the base for advanced financial models. Combining the three primary financial accounts makes it easier to browse, reduces the chance of formula mismatches, increases organization, and provides greater capacity for consolidation.