3 Statement Model

A 3-statement model is a type of financial model that integrates three key financial statements: the Income Statement, the Balance Sheet, and the Cash Flow Statement. These statements are interconnected, allowing for comprehensive analysis and forecasting of a company's financial performance.

Here's a step-by-step guide on how to create and maintain a 3-statement model, using a simplified example:

Step 1: Gather Historical Financial Data

Collect historical financial data for at least 3-5 years. This includes:

  • Income Statement: Revenue, Cost of Goods Sold (COGS), Operating Expenses, Interest, Taxes, and Net Income.
  • Balance Sheet: Assets (Current and Long-term), Liabilities (Current and Long-term), and Equity.
  • Cash Flow Statement: Cash from Operations, Investing, and Financing activities.

Step 2: Build the Income Statement

  1. Start with Revenue: Project future revenue based on historical growth rates or other assumptions.
  2. COGS and Gross Profit: Estimate COGS as a percentage of revenue to derive Gross Profit.
  3. Operating Expenses: Estimate future operating expenses (e.g., SG&A, R&D) as a percentage of revenue or based on fixed growth rates.
  4. Operating Income: Subtract Operating Expenses from Gross Profit.
  5. Interest and Taxes: Estimate interest expenses based on debt levels and apply an estimated tax rate.
  6. Net Income: Subtract interest and taxes from Operating Income.
Example:
  • Revenue (Year 1): $1,000
  • COGS (60% of Revenue): $600
  • Gross Profit: $400
  • Operating Expenses (30% of Revenue): $300
  • Operating Income: $100
  • Interest Expense: $10
  • Taxes (30% of Operating Income): $27
  • Net Income: $63

Step 3: Build the Balance Sheet

  1. Link Net Income to Equity: Add Net Income from the Income Statement to Retained Earnings in Equity.
  2. Estimate Asset Changes: Project changes in Current Assets (e.g., Cash, Accounts Receivable) and Long-term Assets (e.g., Property, Plant, Equipment).
  3. Estimate Liabilities Changes: Project changes in Current Liabilities (e.g., Accounts Payable) and Long-term Liabilities (e.g., Debt).
Example:
  • Current Assets: Cash ($100), Accounts Receivable ($200)
  • Long-term Assets: PP&E ($500)
  • Current Liabilities: Accounts Payable ($150)
  • Long-term Liabilities: Debt ($300)
  • Equity: Common Stock ($200), Retained Earnings (Net Income + Previous Retained Earnings)

Step 4: Build the Cash Flow Statement

  1. Cash from Operating Activities: Start with Net Income, adjust for non-cash items (e.g., Depreciation) and changes in Working Capital.
  2. Cash from Investing Activities: Project capital expenditures (CapEx) and other investment activities.
  3. Cash from Financing Activities: Project changes in debt, equity, and dividends.
Example:
  • Cash from Operations: Net Income ($63) + Depreciation ($20) - Increase in Accounts Receivable ($10) + Increase in Accounts Payable ($5) = $78
  • Cash from Investing: CapEx ($50)
  • Cash from Financing: New Debt Issued ($100) - Debt Repayment ($30) - Dividends ($10) = $60

Step 5: Link the Statements

  1. Link Net Income: From the Income Statement to the Cash Flow Statement and Balance Sheet.
  2. Link Depreciation: From the Income Statement to the Cash Flow Statement.
  3. Link Changes in Working Capital: From the Balance Sheet to the Cash Flow Statement.
  4. Link Ending Cash: From the Cash Flow Statement to the Balance Sheet.
Example:
  • Ending Cash Balance: Beginning Cash ($50) + Cash from Operations ($78) + Cash from Investing (-$50) + Cash from Financing ($60) = $138

Step 6: Validate the Model

  1. Check for Consistency: Ensure all links are correct and the statements balance (e.g., Assets = Liabilities + Equity).
  2. Perform Sensitivity Analysis: Test the model under different scenarios (e.g., changes in revenue growth, interest rates).

Step 7: Update and Maintain the Model

  1. Regular Updates: Incorporate actual financial results regularly (e.g., quarterly).
  2. Reforecasting: Adjust assumptions and projections based on new information or changes in the business environment.
  3. Review and Adjust: Periodically review the model for accuracy and make necessary adjustments.

Summary

A 3-statement model provides a comprehensive view of a company's financial health by integrating the Income Statement, Balance Sheet, and Cash Flow Statement. Maintaining it involves regularly updating it with actual data, validating consistency, and performing scenario analysis to ensure it remains a reliable tool for decision-making.


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