Building a 3-statement financial model is the most detailed way to create a discounted cash flow and estimate a company’s intrinsic value. By having all 3 financial statements, the balance sheet, income statement, and cash flow, investors can then seamlessly estimate a company’s value in any approach they desire.
Also, with a 3-statement financial model, all the information is at hand to answer hard questions such as how much financing will be needed to carry out the growth plan or how much cash can be returned to shareholders in the form of dividends and share repurchases.
This series of articles will also teach users how and when to construct various supporting schedules to the financials. For investors interested in a pre-built financial model where they can punch in the financial data of any company of interest, they can check out our financial model template (available soon!).
After an analyst has gathered historical data and forms their assumptions on growth and future operating metrics, they can then begin creating the financial statements. The general sequence in creating a 3-statement financial model is seen below. It is an iterative and linked process which allows models to flow smoothly from one statement to the next. The fundamental accounting equation will always need to balance and cash on the balance sheet will roll perfectly year to year.
Steps to Building a 3-Statement Financial Model:
- Gather Historical Data and From Future Assumptions
- Forecast the Income Statement
- Create Supporting Schedules such as Fixed Assets and Debt
- Forecast the Balance Sheet
- Forecast the Cash Flow Statement
Using Historical Data to form Relationships
Projections need a solid base in reality and this is done by using historical financial data to form relationships which can then be carried forward into future years. If any metric has been steadily changing in a certain direction, it would be most wise to take the latest level. As always, using more years of historical data can help form a more accurate average. Good financial models not only tell users the historical ratio but also easily allow users to override the data if needed.
Developing “Drivers” for Significant Items
Forecasting across the statements can be done by determining the “drivers” which are variables that drive an account’s activity or balance. The most common driver is revenue which is used for a number of accounts notably on the income statement but revenue can also effect the assets on the balance sheet needed to support sales. As investors, get more comfortable with the “drivers” behind various accounts, adding in new line items and further segmenting data will become second nature.
Use Separate Schedules for Complex Accounts
Some of the more complex accounts deserve their own schedule. Some of the more common schedules are for fixed assets, debt, equity, and the number of shares outstanding. Even revenue and cost of goods sold can be further segmented if the analyst has the necessary knowledge of the business. Supporting schedules can be used to breakdown the running balance of an account (as is the case with fixed assets, debt, and equity) or can also be used to segment data and apply different margins and growth rates (as is the case with revenue and COGS).
Side Note: One of these more integrated accounts, equity, actually has its own statement in the face of actual financial statements as some knowledgeable readers might be aware. The statement of changes to shareholders’ equity, shows the equity activity broken into share capital issuance and repurchases, dividends, stock-based compensation, and non-controlling interest and retained earnings.
Double Check Your Work!
In order for the forecasted information generated by a 3-statement model to be reliable, the model needs to to respect the rules of accounting and be logical and conservative in the assumptions. As such, there are two important checks that should be performed before an analyst can call their model complete.
- The balance sheet must “balance” – If the balance sheet does not balance, that means that the model is not fully integrating fully and that some movement on the balance sheet is not being represented on the incomes statement and/or statement of cash flows.
- Ratios must be Realistic – Forecasted ratios should be reviewed to make such that the model is not suddenly expecting ROE, net income margins, or any other ratio to be overly optimistic or pessimistic. Ratios should be compared to the historical average and recent readings with any changes to such being able to be reasonably explained.
Once the model is checked and reliable, investors can use it as the input for a number of valuation approaches. For internal company management, the 3-statement financial model can be used as a forecasting and budgeting tool to help drive decisions about financial needs and opportunities. The 3-statement model and valuation template by Cameron Smith, CPA (coming soon!), comes with six valuation techniques to give investors to get a broad valuation perspective.