When it comes to complex financial analysis, a 3-statement financial model is a must-have analytical skill. It is widely used by financial analysts as well as investment bankers. The precision and accuracy of reaching data-driven financial conclusions and key insights made it popular in the corporate finance sector.
In this post, we will explain the fundamentals of a 3-statement model, its key components, and how it works.
What is a 3-Statement Financial Model?
A three-statement financial model is used by financial analysts to integrate the three major financial statements Income Statement, Balance Sheet, and Cash Flow Statement. The 3-statement model integrates these 3 fundamental statements into one framework.
A three-statement model allows analysts to analyze past financial performance, assess the upcoming financial results of a company, and generate a complete financial picture of a company around growth prospects, return on investment, and liquidity of assets.
This financial statement modeling framework reveals all the actionable financial insights and data points about the Income Statement, Balance Sheet, and Cash Flow Statement. Instead of accessing data and relevant financial insights from these 3 statements, analysts, decision-makers and stakeholders can access all the information of these statements through a single and robust framework.
Key Advantages of Developing a 3-Statement Financial Model?
There are multiple advantages of a 3 statement model. Financial analysts, corporate finance professionals, decision-makers, and investors look up to this model for company evaluation and growth assessment. The model is also used to assess the feasibility of financial claims and projected growth prospects. It is often used to determine the prospects of a venture or a business acquisition. A 3-statement model test is often conducted to evaluate the analytical capabilities of analysts.
What are the key skills required for a 3-statement financial model?
Banks and financial institutions frequently test candidates on this skill during their interviews. Some of the must-have skills for 3-statement modeling include proficiency with Microsoft Excel, knowledge of accounting principles and best practices, and predictive analytics skills using financial data.
Do you want to shape your 3-statement financial model to perfection? Follow these steps.
Step 1: Gather Historical Data and Format Your Model
- Right Data Gathering
Way before you start with the Excel document, collect a large volume of historical financial data through the company’s annual reports over the years. Apart from this you also need to gather as many corporate presentations as possible from the investors. You must fill up SEC forms with disclosures of other financial information not covered by the annual reports.
- Follow Best Formatting Practices
For creating a 3-statement financial model that allows easy search, filtering, and navigation, you must adhere to the time-tested best practices such as conventional color coding like black for formula, red for reference to external sources, and green for accessing other worksheets selectively.
Step 2: Define a specific time window
For creating the model, you must focus on data within a specific timeframe. Based on this model can be annual, quarterly, monthly, or weekly. Both DCF valuations and LBO models belong to annual models as they involve long-term financial forecasts. Financial planning and credit analysis suit the quarterly models best.
Monthly models can be used for financial projections and tracking the liquidity of assets. Shortest time windows belong to weekly models and these are used for quick assessment of financial risks and cash flow.
Step 3: Integrating Income Statement
The stage of the creation of the income statement model involves incorporating the company’s income data from sources ranging from 10-K filings or direct data import using FactSet or Capital IQ tools.
After integrating the income statement data, the base forecast for revenue is calculated based on business-specific factors, financial trends, and minimum growth rate consistency over the years. The income statement also opens up the scope of other forecasts regarding operating expenses, depreciation and capital expenditure, and taxes.
Step 4: Create the Balance Sheet
As we all know the balance sheet represents the overall financial condition of a business. By leveraging 3 statement model templates we can also forecast the position of a company as per its future balance sheets. This forecasting also involves incorporating different aspects from income statements such as assets, liabilities, capital expenditure, and equity.
Step 5: Create the Cash Flow Statement
Finally, the cash flow statement aligns with both the income statement and the balance sheet. To build his statement you need to create three sections Operational Activities, Investment Activities, and Financing Activities. This statement is more for aligning with the previous two models.
Step 6: Integrate the Three Statements
Now you need to integrate all three models. Proper integration within one 3-statement model guarantees that any change in any of the constituent statements is likely to impact the others.
Following complete integration, net income will be part of the balance sheet data and both depreciation and amortization will be part of the cash flow statement. From the balance sheet working capital will appear in the cash flow statement. In the cash flow statement debt and equity charges will be added with links to the balance sheet.
Step 7: Test the Model
Now that you have built a fully-fledged 3-statement model, it is time for testing and quality assurance. The model test begins with stress testing. How easily the model performance is impacted by changes in figures corresponding to the revenue, expenses, or funding, is evaluated in this stage.
The new 3-statement financial model needs to be checked for unwanted errors as well. Here some Excel features and tools such as auditing can be used to identify errors easily. Last but not least, all constituent statements must sync with each other.
Ending Notes
So, shaping a 3-statement model to perfection requires financial knowledge, excel skills to manipulate different data fields and formulae, and great eyesight for detail. Though it sounds technical enough, creating a fine-tuned three-statement financial model can be much easier when you build your knowledge around each statement and upskill your manœuvrabily.
