Building a three statement operating model has been an integral part of any organization, either by investor analyst or any associate. Hence, finance professionals must be adept in making a three-statement financial model by doing their daily practice. Here, you will understand Building an Integrated 3 Statement Financial Model basics and how to build its integrated version.
3 statement financial model is perhaps the basic version of financial modeling as it accounts for all the financial statements; income statements, balance sheets, and cash flow statements. Creating this financial model helps you take a step further than just simple accounting.
The first financial statement that we will talk about is the income statement. As we all know, the income statement exhibits the company’s profitability. It is the key statement that business owners, investors, and other creditors look at to verify whether the business is generating profits or not.
When it comes to creating a financial model and forecasting the income statement, analysts take a minimum of years of data. Doing so helps in creating assumptions or following pre-existing patterns. Once the historical data is on the excel file, analysts make assumptions and figure out the level of sales for the forecast.
Forecasting an income statement requires vigilance as you need to factor in various challenges to create accurate assumptions. Moreover, the income statement impacts the balance sheet and cash flows; therefore, making sure it’s accurate is essential.
Next, we have the balance sheet or financial position statement, mainly referred to as. Here, you get to see all the assets, liabilities, and capital of your business. So, you can agree on how essential it is to make sure that you’re making accurate assumptions for this statement.
When it comes to the data, you will add the historical data in the same manner as you did with the income statement. A minimum of years of data is to be worked on and used for making assumptions and forecasts. It portrays its overall performance in the last few years and becomes the definitive statement that almost every interested party reviews.
For the formation of assumptions, much of the balance sheet’s assumptions are linked to the income statement. Working capital elements and capital expenditure is linked to the assumptions you create for the revenue. As you integrate each statement to another, you will find a massive impact throughout your financial model of any change in the income statement.
Finally, we have the cash flow statement that is third and the last in line when it comes to the 3 statement financial model. Here, you will find a range of things happening. But mostly, it will be the yearly changes in the balance sheet presented here. The main thing to notice about the cash flow statement is that it represents only cash-based changes, as the name suggests.
When it comes to forecasting the cash flow statement, you should know that there is none. Instead, cash flow statements take all of their information from the balance sheets. So, if your assumptions are accurate, then your forecasted cash flow statement will have no reconciliation issues either.
Building a financial model to assess the company’s financial performance, making assumptions for its projection, and calculating the income statement are of utmost importance. But what completes the Financial model with greater understanding and full insights of the company’s performance is when we have the well-integrated Balance sheet and a Cashflow statement. This helps to forecast cash flows and then create a business budget. You will have to look at the number of things when creating a 3 statement financial model.
It would be best to be careful about the three main things when making a financial model; formatting, periodicity, and the financial model structure. Each of these has an immense amount of importance.
When it comes to the 3 statement financial model format, make sure you follow standard procedures. Don’t try to make too many variations. But what are those standard practices and procedures?
Follow a basic color code throughout your financial model to make them easier to understand. If you follow just a single color code, it will get difficult for you to set apart your inputs, formulas, and links. Also, make sure that you are consistent with your data format. If you are using two decimal places for your values, then stick to it with the same rule throughout your financial model.
Next, we have periodicity. What does this mean? Essentially, this refers to the periods that you divide your financial model. There are four variations that you will find here; annual, quarterly, monthly, and weekly.
You can use any of these variants when creating your 3 statement financial model. However, when it comes to the presentation of it, the annual periodicity is always considered. When it comes to working, you can get into more details through the other methods.
The most common uses of the annual variation are to figure out the Discounted Cash Flow (DCF) value. Yearly cash flows are taken to figure out where the business stands by the end of a specific time frame. Moreover, quarterly and monthly 3 statement financial models eventually are converted to annual ones. The weekly one is used to keep a check on the cash and liquidity of the business.
Now, when it comes to the structure of the financial modeling excel, you want to ensure you’re following a particular structure. It holds especially for extensive 3 statement financial models. You don’t want to have a haphazard financial model. It will make it difficult for you to understand and will drive away any potential investors.
Ensure that your assumptions or inputs are in a separate sheet so that it is easier for you to know every aspect of the financial model. Moreover, you will also need to ensure that you’re not going excessive when linking files. If you move around your financial model to different devices, it will get difficult to keep track of all the data coming into your financial modeling.
You can build several ways, either on separate sheets or on the one beneath the income statement.
Now, you must be wondering what an integrated version of a 3 statement financial model looks like. Well, it is pretty similar, but it is more connected internally. What does this mean? Why our 3 statement financial model is primarily built on assumptions that you input. In the integrated version of a 3 statement financial model, you will see that each financial statement is better linked.
Essentially, any change in the assumptions will automatically show a clear impact throughout the financial model. Since the income statement, balance sheet, and cash flow statement are thoroughly linked here; you will see a significant impact of any change in the assumptions.
However, integrating the 3 statement financial model requires the right skills. Your CFO will have to be highly skilled to ensure that they make a robust financial model for your business. Financial modeling is not something just anyone can do. You need to make sure that you have an experienced CFO service on board to make your financial models flawless.
As you create your 3 statement financial model, you need to have all the relevant data beforehand. You will need to gather all the historical data before you go on to creating your financial model. But that’s not all. Financial modeling excel requires you to have a multitude of data for you to work.
Analysts or any other CFO services working to create the 3 statement financial model will require financial reports, tax filings, research reports, and anything else that can help form an accurate financial model. Therefore, it is no easy task and requires you to collect adequate data for the entire process. It’s best to let a professional who has sufficient knowledge about all the data handle this. You can reach out or outsource a CFO service to prepare for your financial modeling excel needs.
After you have jotted down historical data on the Incomes statement and Balance sheet, you can use these numbers and calculate the respective ratios such as:
The use of these ratios helps you in making assumptions which ultimately leads to making projections.
After assumptions drawn from historical data, you can now make projections for up to five years. We can assume revenue growth to be stronger in upcoming years, be steady, or drop due to many factors. And thus use the Growth formula to calculate each next year’s revenue. For COGS, if a company is predicted to grow in the coming years, we can foresee that gross margin will grow too, and COGS to decrease due to operating leverage. Likewise, tax rate, interest expense has different assumptions; they may grow at a constant rate, or there may be a 0.5% (it may change) increase or decrease.
This Net Income drawn out of the Income Statement will be linked with the model’s other financial sheets. If you think you might have made a mistake, check your errors before you proceed further.
Average ratios such as Account Receivable days, Accrued expenses, Days account payable, and other ratios are calculated, the constant result is used for forecasted years. You may change or keep the average of these ratios for projection. Once done, we can move towards a cash flow statement. Cash, debit and shareholder equity might remain vacant as they are derived from the cash flow statement.
The majority of heads of Cash Flow Statement are derived from the balance sheet and income statement. As we have subtracted depreciation and amortization, we have to back here in Net Income as there arent cash expenditures. If Account receivables and inventory increase, it doesn’t have a good impact on the statement as the company itself hasn’t received any cash, and rather it has been spent. For Account, payable vice versa happens. The company’s net income will be equal to Year X Ending cash balance = Ending Cash Balance of Year (X-1) + Cash from Operations of year X + Cash from Investing Activities of X + Cash from Financing activities of that year.
Calculate all the remaining heads such as Net PPE, long term debt, shareholders equity. Link the beginning and ending cash flow between the balance sheet and cash flow statement. once done, make sure for the Balance sheet, Total Asset= Total Liabilities+ Owners Equity
You will have to look at a few things when it comes to financial modeling excel. These are additional items when it comes to creating an integrated 3 statement financial model.
These are essentially salient cash features of the model that are integral to measuring the shortage and surplus. The credit line and revolver are two plugs used by financial analysts to create financial models.
The revolver considers any amount of shortage when it comes to cash. If there is a shortage, the revolver adjusts to meet the requirement of the shortage. At the same time, the credit line ensures that any amount of surplus is accumulated there.
Another thing to consider is the circularity in the financial model. Circularity is when one calculation depends on itself for any outcome. One of the main reasons why this might arise is because of the model plugs present. It can be highly destructive for the entire financial model.
You want to make sure a professional handles these details to not end up with an ineffective financial model. Professionals make use of the excel option to help with the circularity challenge. However, this doesn’t always ensure that there are no mistakes. Sometimes, there is a need for manual changes to help get rid of the circularity issues.
As you create your financial model, you have to ensure that you conduct tests and analysis to see its effectiveness. Two main analyses need to be conducted to ensure that your integrated 3 statement financial model is created the right way.
The sensitivity analysis focuses on one output of the financial model and how one or two inputs attached to it affect it—observing the EPS changes while making changes in the revenue growth or margins. If your financial model allows you to make these changes and see the desired outcome, you’re sure to have created a robust 3 statement financial model.
Another largely used analysis is scenario analysis. Here, you will test out various assumptions of the finance, operating, or investing aspects that change the outcome. You do this once you have completed creating your initial model. As that comes to an end, you can test out how different assumptions will impact your results. It is highly relevant to test out whether your 3 statement model is integrated the right way.
Like other aspects of your business, you need to ensure that you have the right people overlooking your finance department. When it comes to creating financial models, you should choose the ultimate CFO service for your needs. Get your financial model prepared by professionals in the business.
We, at Oak Business Consultants, provide expert consultancy in such matters. With vast experience in creating robust and extensive financial models, you will find our service exceptional.