3 Way Financial Model: A Complete Guide On What It Is & How To Building One

What the company’s financial future might look like can be seen in a financial model, which is like a crystal ball. The three-statement model is a useful way to think about money.

The balance sheet, cash flow statement, and income statement are all drawn up by the computer. That’s why it’s called the “three-statement model.”

We will walk you through each step of making a three-statement model in this guide.

What is a 3-Way Financial Model?

A 3-way financial model is a way to report a company’s finances that uses three main lines to figure out how healthy its finances are:

• Profit and Loss Statement (P&L): Shows how much money the company made and spent over a certain period, showing whether it made a profit or lost money.
• Cash Flow Statement: This shows how much cash comes in and how much cash goes out.
• Balance Sheet: This is a picture of what the company owns (assets) and owes (liabilities) at a certain point in time. It shows cash on hand and upcoming loan payments.

All of these statements together show how well a company is doing, its financial state, and what changes need to be made for future choices.

Why is it important to use the 3-Way Financial Model?

The three-way financial model is very important because it shows how choices affect financial statements that are linked to each other. It helps companies figure out how decisions about operations (like cutting costs or selling more), investments (like buying equipment), and finances (like loans or giving out shares of stock) affect their total profit, cash flow, and ability to stay in business.

This model is especially useful in complicated situations like mergers and acquisitions, where it’s important to know how the combined companies will affect their finances to make smart decisions. It is also an important part of financial planning because it helps companies guess how they will do in the future and make choices that will help them grow while avoiding possible financial problems.

The 3 Core Elements of the 3-Way Financial Model

Income Statement

The income statement, also called the profit and loss statement, shows how much money a business made and lost over a certain period. It keeps track of revenues and costs, and to find the net profit or loss, costs are subtracted from revenues.

To predict it, you guess how much money you’ll make in the future from sales and other sources, as well as how much money you’ll spend on things like rent and pay. The balance sheet and cash flow statement are affected by this statement because numbers like depreciation change the prices of assets and income.

Balance Sheet

The assets, liabilities, and owners’ stock on the balance sheet show how a company’s finances were doing at a certain point in time. When the income statement changes, it affects the balance sheet.

For example, when gains rise, equity goes up. Buying assets adds to the total value of the business’s assets, but payments for bills or purchases can affect cash flow.

Cash Flow Statement

With the cash flow account, you can see at a glance how much cash is coming into and going out of the business. It checks that the changes in the balance sheet accounts match up with the net income on the income statement.

For example, sales that are shown on the income sheet might not show up in cash flow until the money comes in. This statement is very important for knowing how much cash the company has left after non-cash costs and changes in its assets or debts have been taken into account.

Also Read – 8 Types of Financial Models, Their Applications & Examples

Step-by-Step Guide to Building a 3-Way Financial Model

Gathering Historical Data

Getting correct past data is the first thing that needs to be done to build a 3-way financial model. This information gives you a base for your plan and shows you how the business has done in the past.

• Why info from the past is important: It is very important because it helps us understand patterns and trends, which helps us guess what will happen in the future. Your predictions might not be accurate if you don’t have good facts from the past.
• Where to look for it: The EDGAR website has SEC files, like 10-K and 10-Q reports, that make it easy to get financial information about companies that are sold on the stock market. If you’re modelling for a private company, you’ll need to use internal financial information, which can be hard to find.
• Putting the facts in order: When you have the information, you need to put it into the three main financial statements: the Income Statement, the Balance Sheet, and the Cash Flow Statement. This means putting out past data in Excel in a way that makes it easy to understand and makes it possible to make accurate projections.
• Why historical data matters: It is crucial because it gives insights into trends and patterns, which can inform future predictions. Without reliable past data, your forecasts may not reflect reality.
• Where to find it: For publicly traded companies, you can easily access their financial data through SEC filings (such as 10-K and 10-Q reports), which are available on the EDGAR database. If you’re modelling for a private company, you’ll need to rely on internal financial reports, which can sometimes be harder to obtain.
• Organising the data: Once you have the data, you’ll need to organise it into the three core financial statements—Income Statement, Balance Sheet, and Cash Flow Statement. In Excel, this means clearly laying out historical data in a format that is easy to follow and will allow for accurate projections.

Making Assumptions

The next step is to make a set of key assumptions about the company’s future performance. Assumptions drive the model, as they allow you to forecast how the company might perform in different scenarios.

• Revenue growth: Start by making assumptions about how much you expect the company’s revenue to grow. This could be based on historical growth rates, economic conditions, or competitor performance. For example, if your company has been growing revenue at 10% annually, you might assume a similar growth rate going forward.
• Expenses: You’ll also need to forecast how various expenses (such as operating costs, sales, and marketing) will change over time. This can be done manually or by using tools like forecasting software.
• Working capital assumptions: These include how long it takes to collect receivables, how long you hold inventory, and how long you have to pay your suppliers. These metrics help you estimate the company’s short-term financial health.
• Capital expenditure (CapEx) and depreciation: If the company is planning to invest in new equipment, offices, or infrastructure, you’ll need to include these investments in your model. You’ll also have to calculate depreciation (the reduction in value of assets over time), which affects both the income statement and balance sheet.
• Financing: Decide how the company will finance its growth. Will it rely on debt or equity? Assumptions around financing decisions will impact the interest expense on the income statement and the cash flow from financing activities.

Assumptions should always be reasonable, and it’s helpful to base them on historical trends and future expectations. If you’re not sure how to structure them, using a 3-way financial model template can make the process much easier, as it often includes common assumptions you can tweak.

Building the Income Statement

Once you’ve gathered historical data and made your assumptions, the next step is to build the income statement.

• Revenue forecast: Begin with the revenue forecast, the top line of your income statement. Project revenue for the next few periods (e.g., quarterly or annually) based on the growth rate you assumed earlier.
• Expenses: Forecast all types of expenses, such as cost of goods sold, administrative expenses, and marketing costs. These expenses, subtracted from revenue, give you the operating income.
• Other line items: After calculating operating income, add or subtract other items, such as depreciation, interest expenses, and taxes, to calculate the net income.
• Linking to other statements: The income statement is not a standalone document. You’ll need to link it to both the balance sheet and cash flow statement. For example, net income from the income statement flows into the equity section of the balance sheet and serves as the starting point for cash flow from operations in the cash flow statement.

By forecasting revenue and expenses, the income statement gives a clear picture of the company’s future profitability.

Also Read – Top 14 Financial Forecasting Models for Accurate Projections

Building the Balance Sheet

The next step is to forecast the company’s assets, liabilities, and equity by building the balance sheet. This statement reflects the company’s financial position at a specific point in time.

• Assets: Start by forecasting the company’s assets, such as cash, inventory, and property. The value of assets changes over time due to factors like capital expenditures (buying new assets) and depreciation (assets losing value).
• Liabilities: Forecast the company’s liabilities, including short-term liabilities (like accounts payable) and long-term liabilities (such as loans or debt). Financing assumptions are important here, especially if the company plans to take on new debt for growth.
• Equity: Equity represents the owner’s interest in the company, including retained earnings and any new equity financing. Link the net income from the income statement to the retained earnings section in the equity part of the balance sheet.
• Cash balance: The final cash balance on the balance sheet comes from the cash flow statement, ensuring that all three statements are interconnected.

A properly constructed balance sheet shows whether the company has enough assets to cover its liabilities and how much is financed by equity versus debt.

Building the Cash Flow Statement

Finally, build the cash flow statement, showing how cash moves in and out of the business. It has three sections: operating activities, investing activities, and financing activities.

• Cash from operations: This section starts with net income from the income statement and adjusts for non-cash items like depreciation. It also accounts for changes in working capital, such as accounts receivable, inventory, and accounts payable.
• Cash from investing activities: This includes cash spent on capital expenditures, like new equipment or office space, or cash earned from selling assets.
• Cash from financing activities: This section reflects changes in the company’s debt and equity, such as cash inflows from new shares or borrowing, and cash outflows from repaying debt or paying dividends.
• Linking cash to the balance sheet: After calculating the net cash flow (cash inflows minus cash outflows), link the final closing cash balance for each period back to the balance sheet.

By linking the income statement, balance sheet, and cash flow statement, you create a comprehensive 3-way financial model that provides a detailed picture of the company’s financial health. This model helps in understanding how different factors impact each other and is essential for making informed business decisions.

Also Read – What is Leveraged Buyout Modeling & how can you learn it?

Best Practices for Building a 3-Way Financial Model

Consistent Formatting

Using a standard format makes a 3-statement financial model clear and easy to understand.

• Color codes: Use different colors to distinguish various types of information:
  • Inputs (blue): For numbers and factors entered manually, making it easy to identify editable values.
  • Formulas (black): To indicate formula-based cells, so their source is identifiable.
  • External Links (green): To show data sourced externally, helping with traceability and transparency.
• Consistent units and decimal places: Using the same units throughout, such as thousands or millions, reduces misinterpretation or errors. Keeping the number of decimal places uniform (e.g., two decimal places for financial figures) improves readability.

Avoiding Common Mistakes

• Circular References: A circular reference occurs when a formula refers back to its own cell, making calculations unclear. Double-check formulas to avoid such issues.
• Unfinished Inputs: Missing inputs can lead to incomplete calculations. Regularly review your model to ensure all necessary data is entered.
• Excel Error Checking Tools: Excel’s built-in tools can help find common issues, like calculation errors or inconsistencies.
• Avoiding Hard-Coded Values in Formulas: Instead of entering numbers directly into formulas, use input cells as references, making it easier to update the model.

Using a 3-Way Financial Model Template

A template streamlines model-building by providing a pre-made structure, reducing errors, and guiding beginners.

• Benefits of Using a Template:
  • Saves Time: A template provides a ready-made structure, speeding up model-building.
  • Reduces Errors: Templates have built-in formulas and layouts, allowing you to focus on data input rather than structure.
  • Guidance: Templates help beginners organize information and know what to include.

Also Read – 9 Best Financial Modelling Courses – Online & Offline

Advanced Features: Scenario and Sensitivity Analysis

Scenario Analysis

Scenario analysis allows you to assess how different business decisions could impact financial outcomes by modeling various “what if” scenarios.

Examples:

• Best-Case Scenario: Positive outcomes, like a successful product launch, driving revenue.
• Worst-Case Scenario: Potential risks, such as increased competition or customer attrition.

Changing variables in your model reveals how different scenarios affect financial areas like profit, expenses, and cash flow, preparing you for both favorable and unfavorable situations.

Sensitivity Analysis

Sensitivity analysis helps understand how changing a single factor, like revenue growth, impacts overall financial results.

Examples:

• Revenue Growth: Examining the effects of price increases on profit margins.
• Profit Margin: Assessing how cost changes impact net income.

Adjusting one variable at a time helps you make more informed decisions by showing the potential impact of specific adjustments.

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FAQs

1. What is a 3-way financial model used for?

A 3-way financial model is used to project a company’s financial performance by integrating three core statements: the income statement, balance sheet, and cash flow statement. This model aids in analyzing historical data, making future forecasts, and supporting finance and investment decision-making processes.

2. Can I use a 3-way financial model template to build my model?

Yes, using a 3-way financial model template is highly recommended, especially for beginners. Templates offer pre-built structures and formulas, making it easier to input your data and create a cohesive model without starting from scratch.

3. How long does it take to build a 3-statement financial model?

The time required to build a 3-statement financial model depends on your familiarity with financial concepts and Excel. Experienced professionals might take a few hours, while beginners may need a few days to complete the model thoroughly.

4. What is the most challenging part of building a 3-way financial model?

One of the most challenging aspects is ensuring all components are accurately linked and that assumptions are realistic. Identifying potential errors, such as circular references or incorrect assumptions, can also be difficult for newcomers.

5. Can I build a 3-way financial model without advanced Excel skills?

Yes, basic Excel skills are sufficient to build a 3-way financial model, though familiarity with Excel functions and formulas will be beneficial. Using a template can simplify the process, enabling you to focus on financial analysis rather than complex Excel tasks.

6. What is the main difference between scenario analysis and sensitivity analysis?

Scenario analysis explores multiple hypothetical situations (e.g., best-case, worst-case) to understand potential financial impacts, while sensitivity analysis focuses on the effect of changing a single variable on the overall outcome. Both analyses are valuable for strategic financial planning.

7. How frequently should a 3-way financial model be updated?

Typically, models should be updated monthly, quarterly, or annually, depending on the company’s needs and the availability of new data. Regular updates ensure the model remains accurate and relevant for decision-making.

8. Is it necessary to link all three financial statements in a 3-way model?

Yes, linking all three statements—income statement, balance sheet, and cash flow statement—is essential for accuracy, as each statement impacts the others. This interconnection provides a comprehensive view of the company’s financial health.

9. What are some common errors to avoid in 3-way financial modeling?

Some common mistakes include circular references, missing inputs, and hard-coded values in formulas. Following best practices like using color codes and Excel error-checking tools can help avoid these issues.

10. Why is the income statement usually created first in the 3-way financial model?

The income statement is generally created first because it details the company’s revenue and expenses, leading to net income. This net income figure then flows into both the equity section of the balance sheet and the operating cash flow section of the cash flow statement, allowing for accurate linking across all three statements.

A 3-way financial model is a powerful tool for gaining insights into a company’s financial future. With diligent setup and regular updates, it becomes a foundation for informed business strategy and long-term planning.