What is a 3-Statement Model?
The purpose of a 3-statement model or financial model is to forecast or project the financial position of a company as a whole. It links the three types of financial statements – balance sheet, income statement, and cash flow statement. Therefore, if there is a change in one financial statement, the other financial statements should adjust accordingly.
To understand the high-level steps required to build a 3-statement model, it is important to have the iterations setting in Excel turned off before starting.
Key Learning Points
- 3-statement modeling links the income statement, balance sheet, and cash flow statement together for forecasting purposes.
- There are ten steps involved in building a 3-statement model.
- To start 3-statement modeling we need to have the iterations setting in Excel turned off.
10 Steps in Building a 3-Statement Model
In building an income statement (excluding interest), we start with our actual historical figures. From there, we build the forecasts figures for years 1 to 10. Further, we build these forecasts from assumptions for all line items – i.e. revenue, operating expenses, tax, etc. – except for interest.
The ten steps to building a 3-statement model are:
- Input the historical data: start with inputting historical or actual data for the income statement and balance sheet
- Calculate modeling ratios and statistics: from the historical data, calculate the modeling ratios and statistics
- Decide on forecast assumptions: Use the calculated statistics from the past to create financial forecast assumptions into the future e.g. if revenue increased by 5% in the past, we may choose assume 5% in the forecast period too
- Build forecast income statement except for interest: we now have everything we require to actually start building the forecast figures and we start by building the income statement – which will include the revenue going up by 5%
- Build the forecast balance sheet except for cash, revolver, and debt: after building the forecast income statement, we then build the forecast balance sheet and we skip a couple of lines – cash, revolver, and debt – to do at the end of the modeling
- Build the cash flow statement using the rules of cash: after building the forecast balance sheet in the previous stage, we build the cash flow statement using the rules of cash
- Plug cash into the balance sheet from the cash flow statement: the only line items that have not been filled in are all interest-related. We know that cash, revolver, and debt involve interest expense or interest income. We can take cash from the cash flow statement and put that into the balance sheet and thus one of the missing items from the balance sheet is dealt with
- Build the debt and interest calculations: We build the debt and interest calculations and then plug the revolver and long-term debt into the balance sheet. So now, the balance sheet is done and there are no missing line items
- Balance the balance sheet: Once we have put cash, debt and revolver in the balance sheet, many figures will change – a completed balance sheet will change the cash flow statement – which will then change the cash number on the balance sheet. So, the balance sheet should balance.
- Circular references: The only item now missing is interest. We need to link the interest into the income statement and deal with any circular reference that may arise. The interest will lead to some changes in the net income, which will, in turn, affect the cash flow statement and cash on the balance sheet. Assuming we built our model correctly, the balance sheet should still balance.
Building an Income Statement (excluding Interest), Example
In the example below, to build our income statement for a company we start with our actual i.e. historical figures. From there we build the forecasts for 10 years. We build them from assumptions for all line items – i.e., revenue, operating expenses, tax, etc. except for interest (income and expense). Interest can often lead to a circular reference – so we tend to do this at the end of our model.
It is very common to forecast the whole of Year 1’s income statement, before then copying year 1 to subsequent years. Before copying over we do a few modeling error checks on Year 1.
First, we do a sense, structure, and stress check of the Year 1 forecast, – for this, we look back at the historical data and compare. For example, in Year 1 revenues are forecasted to be US$8,800.2, and in the previous (historical) year they were US$7,652.3. So, when compared, the forecast figure does not seem too outlandish i.e. it looks sensible.
We then do a structure check to make sure the Year 1 forecast revenues are linked to Year 1 forecast assumptions.
Lastly, we do a stress test – for example, if we increase our revenues by 10,000, then what might we expect to happen to net income? We should expect the net income to increase by 10,000 less the tax rate. If we put this increase into the revenues and if the net income changes, then we are happy that the model is working as expected, and move on to the next stress test.
You might have noticed that the interest lines (interest income and interest expense) have not been completed at this stage. The final step to complete the income statement is to deal with the circular reference. Once done, the 3-statement model can be checked and be ready for handover.
Before sharing your model with your colleagues, it is important to do a final check of the following:
Download the accompanying Excel exercise sheets to practice your modeling skills.
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Linking Three Financial Statements
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