Table of Contents
- Introduction to 3-statement modeling
- Formatting a 3-statement model
- Model structure
- Basic elements of an integrated 3-statement financial model
- Gathering data ahead of financial modeling
- The income statement
- The balance sheet
- Cash flow statement
- Model plugs: cash and revolver
- Handling circularity
- Calculating shares and earnings per share (EPS)
- Scenario Analysis
- Sensitivity Analysis
- Effective modeling requires a combination of skills
- M&A, DCF and LBO models depend on forecasts produced in the 3-statement model
Introduction to 3-statement modeling
While accounting enables us to understand a company’s historical financial statements, forecasting those financial statements enables us to explore how a company will perform under a variety of different assumptions and visualize how a company’s operating decisions (i.e. “let’s reduce prices”), investing decisions (i.e. “let’s buy an additional machine”) and financing decisions (i.e. “let’s borrow a bit more”) all interact to impact the bottom line in the future.
A well-built 3-statement financial model helps insiders () and outsiders ( , , and ) see how the various activities of a firm work together, making it easier to see how decisions impact the overall performance of a business.,
Formatting a 3-statement model
It is critical that a complex financial model like the 3-statement model adheres to a consistent set of best practices. This makes both the task of modeling and auditing other people’s models far more transparent and useful. We have written an Ultimate Guide to Financial Modeling Best Practices, but we’ll summarize some key takeaways here.
The most basic formatting rules are:
- Color code your model so that inputs are blue and formulas are black. The table below shows other color-coding best practices:
Type of cells Color Hard-coded numbers (inputs) Blue Formulas (calculations) Black Links to other worksheets Green Links to other files Red Links to data providers (i.e. CIQ, Factset) Dark Red
- Format data consistently (for example keep consistent unit scale, use 1 decimal place for numbers, 2 for per share data, 3 for share count).
- Avoid partial inputs that commingle cell references with hard numbers.
- Maintain standard column widths and consistent header labels.
One of the first decisions to make in a 3-statement financial model concerns the periodicity of the model. Namely, what are the shortest time periods the model will be partitioned into: annual, quarterly, monthly or weekly. This will typically be determined by the 3-statement financial model’s purpose. Below we outline some general rules of thumb:
- Annual models: Common when using the model to drive a DCF model valuation. This is because a DCF model needs at least 5 years of explicit forecasts before making terminal value. LBO models are often also annual models, as the investment horizon is around 5 years. An interesting wrinkle with annual models is the handling of the “stub period,” which captures the latest 3-, 6-, or 9-month historical data).
- Quarterly models: Common in equity research, credit, , mergers and acquisitions (accretion/dilution) models where near-term issues are a catalyst. These models often roll up into an annual buildup.
- Monthly models: Common in restructurings and where month to month liquidity tracking is critical. One thing to note is that the data required for a monthly buildup is usually unavailable to outside investors unless it is privately provided by management (companies don’t report monthly data). These models often roll up into a quarterly buildup.
- Weekly models: Common in bankruptcies. The most common weekly model is called the bankruptcy process to track cash and liquidity. The TWCF is a required submission in a
When models get large, adhering to a strict structure is critical. Key rules of thumb include:
- Use roll-forward schedules when forecasting balance sheet items.
- Aggregate inputs in one worksheet or one section of the model and separate them from calculations and outputs.
- Avoid linking files together.
Basic elements of an integrated 3-statement financial model
3-statement models include a variety of schedules and outputs, but the core elements of a 3-statement model are, as you may have guessed, the income statement, balance sheet and cash flow statement. A key feature of an effective model is that it is “integrated,” which simply means that the 3-statement models are modeled in a way that accurately captures the relationship and inter-linkages of the various line items across the financial statements. An integrated model is powerful because it enables the user to change an assumption in one part of the model in order to see how it impacts all other parts of the model consistently and accurately.
Gathering data ahead of financial modeling
Before firing up Excel to begin building the model, analysts need to gather the relevant reports and disclosures. At a minimum, they will need to gather the company’s latest SEC filings, press releases and possibly equity research reports. Data is much harder to find for private companies than for public companies, and reporting requirements vary across countries. We have compiled a guide on .
The income statement
The income statement illustrates a company’s profitability. All three statements are presented from left to right, with at least 3 years of historical results present in order to provide historical rations and growth rates from which forecasts are based. Inputting the historical income statement data is the first step in building a 3-statement financial model. The process involves either manual data entry from the 10K or press release, or the use of an Excel plugin such as Factset or Capital IQ to drop historical data directly into Excel.
Forecasting typically begins with a revenue forecast followed by the forecasting of various expenses. The net result is a forecast of the company’s income and earnings per share. The income statement covers a specified period such as quarter or year.
The balance sheet
Unlike the income statement, which shows operating results over a period of time (a year or a quarter), the balance sheet is a snapshot of the company at the end of the reporting period. The balance sheet shows the company’s resources (assets) and funding for those resources (liabilities and shareholder’s equity). Inputting historical balance sheet data is similar to inputting data in the income statement. The data is inputted either manually or through an Excel plugin.
In large part, the balance sheet is driven by the operating assumptions we make on the income statement. Revenues drive the operating assumptions in the income statement, and this continues to hold true in the balance sheet: Revenue and operating forecasts drive working capital items, capital expenditures and a variety of other items. Think of the income statement as the horse and the balance sheet as the carriage. The income statement assumptions are driving the balance sheet forecasts.
Cash flow statement
The final core element of the 3-statement model is the cash flow statement. Unlike on the income statement or the balance sheet, you aren’t actually forecasting anything explicitly on the cash flow statement and it isn’t necessary to input historical cash flow statement results before forecasting. That’s because the cash flow statement is a pure reconciliation of the year-over-year changes in the balance sheet.
Every individual line item on the cash flow statement should be referenced from elsewhere in the model (it should not be hardcoded) as this is a reconciliation. Constructing the cash flow statement correctly is critical to getting the balance sheet to balance. To see how this done, watch this free lesson on cash flow statement modeling.
Model plugs: cash and revolver
A universal feature of a 3-statement model is that cash and a revolving credit line serve as model “plugs.” This simply means that a 3-statement model has an automatic way of ensuring that, when the model projects a cash shortfall after all the line items are forecast, additional debt via a “revolver” account will automatically increase to finance the shortfall. Conversely, if the model projects a cash surplus, cash will accumulate by the amount of the surplus. While this seems fairly logical, modeling this can be tricky. .
Many financial models have to deal with a problem in Excel called circularity. A circularity in Excel occurs when one calculation either directly or indirectly depends on itself to arrive at an output. In the 3-statement model, a circularity can occur because of the model plugs described above. This makes Excel unstable and can create a variety of problems for those using the model. There are several elegant ways to deal with this issue. To learn more about how to deal with circularity, go to the “Circularity” section of this article about financial modeling best practices.