What Is a 3 Statement Model & How Does It Work?

A 3-statement financial model provides a comprehensive overview of a company’s financial standing. It forecasts future financial performance by connecting operational results, financial position, and cash movements. This model offers insights into a company’s projected financial health, forming a basis for various financial analyses. By linking key financial statements, the model translates assumptions about a company’s operations into quantifiable financial outcomes.

The Three Financial Statements

The income statement, also known as the profit and loss (P&L) statement, illustrates a company’s financial performance over a specific period. This statement begins with revenue, representing the total sales of goods or services. Expenses, including the cost of goods sold (COGS), operating expenses like salaries and rent, and non-operating items such as interest and taxes, are then subtracted from revenue. The final figure is net income, indicating the company’s profitability. This statement helps stakeholders assess how effectively a company generates profits.

The balance sheet provides a snapshot of a company’s financial position at a single point in time. It details what a company owns (assets), what it owes (liabilities), and the owners’ residual claim (equity). Assets are categorized as current, like cash and accounts receivable, or non-current, such as property, plant, and equipment. Liabilities include current obligations, like accounts payable, and long-term debts, such as bank loans. The fundamental accounting equation, Assets = Liabilities + Equity, must always hold true, ensuring its equilibrium.

The cash flow statement tracks the movement of cash into and out of a business over a period. It is divided into three main sections: operating, investing, and financing activities.

Operating activities reflect cash generated from a company’s core business operations, such as cash received from customers and cash paid to suppliers and employees. Investing activities detail cash flows related to the purchase or sale of long-term assets, including property, plant, and equipment, as well as investments in other companies. Financing activities show cash flows from debt and equity transactions, such as issuing new stock or debt, repaying loans, and paying dividends to shareholders. This statement highlights a company’s liquidity and solvency by showing where its cash comes from and where it is used.

How the Statements Connect

The three financial statements are linked, with information flowing between them to provide a cohesive financial picture. Net income, the bottom line of the income statement, serves as a starting point for the cash flow statement. Under the indirect method, net income is adjusted for non-cash expenses, such as depreciation and amortization, and changes in working capital accounts to arrive at cash flow from operations.

Net income also connects to the balance sheet through retained earnings, a component of shareholders’ equity. Each period, the portion of net income not distributed as dividends increases the retained earnings balance on the balance sheet. This link ensures a company’s profitability is reflected in its equity position over time.

Changes in balance sheet accounts significantly impact the cash flow statement. For instance, an increase in accounts receivable indicates that sales were made on credit, leading to a reduction in cash flow from operating activities. Conversely, an increase in accounts payable means the company received goods or services but has not yet paid cash, thus increasing cash flow from operations.

Similarly, changes in long-term assets like property, plant, and equipment (PP&E) directly affect the investing activities section of the cash flow statement. Capital expenditures (CapEx), representing purchases of new PP&E, are cash outflows under investing activities. The ending cash balance reported on the cash flow statement directly feeds into the cash line item on the balance sheet, ensuring the balance sheet remains in equilibrium. This final linkage maintains the model’s integrity and consistency.

Building Blocks of the Model

A 3-statement model is built upon assumptions and drivers that project a company’s future financial performance. These inputs dictate the model’s outputs and are often based on historical data, industry trends, and strategic plans. Developing defensible assumptions requires careful analysis of past performance and external market conditions.

Revenue assumptions estimate future sales, directly influencing the income statement. These projections often consider sales growth rates, pricing strategies, and market share. Cost assumptions include the cost of goods sold (COGS) as a percentage of revenue and operating expenses, such as sales, general, and administrative costs, which can be projected as a percentage of revenue or as fixed amounts.

Working capital assumptions involve projecting current assets and liabilities based on operational efficiency metrics. Common metrics include days sales outstanding (DSO) for accounts receivable, days inventory outstanding (DIO) for inventory, and days payable outstanding (DPO) for accounts payable. These metrics help forecast how efficiently a company manages its short-term assets and liabilities.

Capital expenditure (CapEx) assumptions forecast future investments in property, plant, and equipment, often linked to projected revenue growth or specific expansion initiatives. Financing assumptions encompass elements like debt repayment schedules, potential new debt issuance, equity issuances or buybacks, and dividend policies. These assumptions allow the model to forecast the complete set of financial statements into the future.

Purposes of a 3-Statement Model

A 3-statement financial model serves multiple analytical purposes, providing a framework for understanding and predicting a company’s financial trajectory. One primary use is financial forecasting and planning, where the model projects future performance under various scenarios. This allows businesses to anticipate future revenues, expenses, and cash flows, aiding in strategic decision-making.

The model is also a foundational component for various valuation methodologies. By providing integrated financial projections, the 3-statement model offers the necessary inputs for assessing a company’s intrinsic value.

The model facilitates scenario analysis, allowing users to test the impact of different assumptions on profitability and cash flow. For example, one can analyze how changes in sales growth or interest rates might affect a company’s financial health. This capability helps in understanding potential risks and opportunities.

The model supports capital budgeting decisions by evaluating the financial viability of new projects or investments. It provides a structured way to assess how significant capital outlays will impact the company’s overall financial statements. The 3-statement model offers a framework for performance analysis, enabling both internal management and external stakeholders to understand historical trends and project future financial health.