Building a Three-Statement Model
Why You Need a Three-Statement Model
A three-statement budget model is a powerful tool for CFOs and financial leaders seeking clarity, control, and strategic foresight. Integrating the income statement, balance sheet, and cash flow statement into one cohesive framework, the three-statement model provides a comprehensive view of a company’s financial health and future trajectory.
This holistic financial framework allows CFOs to evaluate how strategic decisions, from capital allocation and M&A to cost-cutting and growth initiatives will impact cash flow, profitability, and liquidity in real time. With built-in scenario analysis, a dynamic three-statement model equips leadership with the agility to respond to changing market conditions and make informed, data-driven decisions.
What Is a Three-Statement Model?
A three-statement financial model is a financial modeling tool that integrates the three core financial statements:
Income Statement: Shows the company’s revenues, expenses, and profits over a period.
Balance Sheet: Outlines the company’s assets, liabilities, and equity at a specific point in time.
Cash Flow Statement: Details the cash inflows and outflows from operations, investing, and financing activities.
The model provides a basis for advanced financial models and creates a holistic forecasting tool that allows you to analyze how modifications to one part of the model could impact the other. This type of dynamic modeling provides an integrated view into a company’s expected financial performance and the implications of various conditions on growth, cash flow, credit metrics and liquidity.
Building The Three-Statement Model
This financial model links the income statement, balance sheet, and cash flow statement, enabling the CFO to assess the impact of various decisions on a company’s future financial and operating performance.
Step One: Set Up the Income Statement
Start by building the income statement, as it is the core driver of your three-statement model. You should start with at least one to three years of historic financials to help inform your future projections. If you are building a monthly model, you should add at least 12 months of actual historic financials, including growth rates and margins. Ensure your income statement includes all necessary components.
Add revenue drivers unique to your business
Revenue: Forecast revenue using your unique business drivers. These could be simply period-over-period growth rates or assumptions for price and volume during the forecast period. If your company has businesses, divisions, products or geographic segments with different growth and/or margin characteristics, the budget model should forecast these segments separately. Be sure to consider seasonality for monthly or quarterly financial forecasts.
Project COGS for various products or divisions
Cost of Goods Sold (COGS): Project the cost of goods sold based on historical margins or other relevant drivers. If you have modeled different businesses, divisions, products or geographic segments, be sure to apply appropriate margin assumptions to each division to capture the impact of the changing business mix on your overall cost of goods sold, gross profit, and gross margins.
Estimate SG&A and other operating expenses
Operating Expenses: Estimate selling, general, & administrative (SG&A) and other operating expenses, which can be driven as a percentage of revenue, based on assumed growth rates, or a mix of fixed and variable assumptions. You do not need to model every category of operating expense separately. Consider grouping categories of expenditures that will grow at similar rates to simplify your model. For example, if you have a fixed expense category that will grow at the level of inflation each year and another category that will rise with the level of revenue, consider grouping each category for simplicity.
Whatever approach you choose, capturing the impact of operating leverage on your business during your corporate budgeting process is essential. If you have a high proportion of fixed costs in your business, as it grows, margins and cash flow will grow faster than revenue. If your company is experiencing challenges, operating leverage can exacerbate the impact on margins and cash flow and require dramatic changes to avoid cash flow or liquidity challenges.
Depreciation: If your business is not very capital-intensive, you can model depreciation with a simple assumption for annual depreciation expense. If the opposite is true, or you are expecting changes in the level or nature of capital expenditures, you may want to build a depreciation schedule that calculates annual depreciation expense by segregating assets into different categories (e.g., buildings, equipment, vehicles, etc.) based on useful lives and depreciation methods. After segregating the assets, you would apply the appropriate depreciation method for each category (e.g., straight-line, where each asset is depreciated evenly over its useful life). Finally, you would divide the asset’s cost by its useful life. You would repeat this same process for new capital expenditures.
Amortization: Amortization of goodwill and intangibles should be forecast based on your company’s circumstances, the existing amortization schedule, and expected amortization of any new goodwill or intangibles.
Interest Expense, Net: Link interest expense directly from a debt schedule, which will capture the interest on both existing and any new debt. Include interest income derived from cash and cash equivalents. This can be netted against Interest Expense on the Income Statement, unless your credit agreement requires you to calculate covenants based on gross interest expense (before interest income).
Practice Note: Building a fully linked three-statement model with a debt schedule will create circular references in MS Excel. You need to turn on Manual Calculation and Iterations to prevent any issues with your file.
Taxes: Apply a tax rate to pre-tax income to calculate taxes and net income. If you are modeling an S Corp or LLC you should make tax distribution assumptions in the cash flow statement (see below).
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Calculate EBIT, EBITDA, and Adjusted EBITDA (after consideration of one-time and non-recurring items) to get a clearer picture of operating performance, profitability, financial covenant performance and valuation implications of your three-statement model.
Step 2: Build the Balance Sheet
The balance sheet provides a snapshot of assets, liabilities, and equity, with critical links to the income and cash flow statements. Consider seasonality for monthly or quarterly balance sheet forecasts when building your three-statement model. If you are building in scenarios, consider the impact of better or worse than expected financial performance on key balance sheet items (receivables, inventory, accounts payable, etc.). The components of the corporate budgeting are assets, liabilities, and equity.
Build in key balance sheet drivers
Assets:
Cash and Cash Equivalents: Linked from the cash flow statement (see below).
Accounts Receivable: Typically driven off assumed account receivable days which represents the average period of time to collect receivables from customers. The basic formula is accounts receivable / revenue per day. For example, for a full year forecast, the calculation would be accounts receivable / (net revenue / 365). For a monthly forecast, the calculation would be accounts receivable / (net revenue / 30). Some practitioners prefer to use average accounts receivable to calculate accounts receivable days.
Inventory: Typically driven off assumed inventory days which represents the average days of inventory based on current performance. The basic formula is inventory / cost of goods sold per day. For example, for a full year forecast, the calculation would be inventory / (cost of goods sold / 365). For a monthly forecast, the calculation would be inventory / (cost of goods sold / 30). Some practitioners will use average inventory balances to calculate inventory days or may use inventory turnover instead. We recommend using inventory days because it allows for easier measurement of cash conversion cycle, which is an important measure of cash flow efficiency.
Other Current or Long-Term Assets: Other current or long-term assets can be modeled based on a percent of net revenue or a percent of operating expenses.
Property, Plant, and Equipment (PP&E): Calculated as the prior period’s PP&E balance plus capital expenditures minus depreciation for the period.
Liabilities:
Accounts Payable: Typically driven off assumed payable days, which represents the average days it takes for your company to pay its vendors. The basic formula is accounts payable / cost of goods sold per day. For example, for a full year forecast, the calculation would be accounts payable / (cost of goods sold / 365). For a monthly forecast, the calculation would be inventory / (cost of goods sold / 30). Some practitioners will use average accounts payable balances to calculate accounts payable days.
Accrued Interest: Accrued interest is the difference between accounting accruals for interest expense and the cash payments made to your lenders. To model this accurately, you should calculate accrued interest for each debt instrument in the debt schedule (see description below). For company’s with minimal debt, it may not be necessary to model accrued interest separately.
Accrued Taxes: Accrued taxes are the difference between accounting accruals for taxes and actual payments of taxes.
Other Accrued Expenses: Other accrued expenses include other items like accrued bonuses and are often projected as a percentage of revenue or operating expenses. You should give consideration to seasonality for monthly or quarterly financial forecasts.
Other Current or Long-Term Liabilities: Other current or long-term liabilities can be modeled based on a percent of net revenue or a percent of operating expenses.
Debt: Linked directly from the debt schedule (see below).
Equity:
Shareholders’ Equity is calculated as prior period shareholders’ equity plus net income from the income statement, minus dividends or other distributions (e.g., tax distributions in the case of S corps), plus new issuances of equity, minus redemptions. Some practitioners will break out the different components of shareholders’ equity, but in our experience, this is an area where you can simplify the model without impacting the utility.
Step 3: Set Up the Cash Flow Statement
Your cash flow statement will have three sections: operating activities, investing activities, and financing activities and link items from the income statement and balance sheet.
Operating Activities
Begin with net income, add back non-cash expenses (like depreciation and amortization), and adjust for changes in working capital items, such as accounts receivable, inventory, and accounts payable. The categories should match the balance sheet exactly to avoid any issues later. Be careful to record the signs correctly: increases in assets are reductions in cash while increases in liabilities are increases in cash.
Investing Activities
Include capital expenditures, which can be projected as fixed inputs if there is a detailed capital investment plan, or as a percentage of revenue or using historical growth rates. If you are developing different scenarios, consider the impact of financial performance that is better or worse than expected on capital expenditure assumptions. If your business is capital intensive consider building a depreciation schedule that allows you to allocate capital among asset categories with different useful life and depreciation methodologies. Once you are finished, link all capital expenditures to the PP&E line in the balance sheet. Be sure to check signs.
Financing Activities
Capture debt repayments and any new borrowings directly from the debt schedule. Include any projected dividends or issuances / redemptions of equity here as well. Be sure to check mathematical signs (positive/negative).
When you sum the cash flow from operating, investing and financing activities, the result is the net change in cash, which is added to the previous period’s ending cash balance to get the ending cash balance for the current period. This ending cash balance should be linked to cash and cash equivalents on the balance sheet.
Most of the cash flow statement items are linked from the balance sheet or income statement, but we recommend building a cash flow drivers section in your model with inputs for capital expenditures, equity issuance, equity redemptions, dividends, and other distributions (inc. tax distributions for S corps or LLCs). We also recommend considering how better or worse than expected financial performance could impact these key drivers.
Build your cash flow statement
A Three-Statement Template You Can Actually Use
A three-statement budget model is a powerful tool that lays the foundation for other financial models that help you manage your bottom line. With our basic free template or our expanded premium model, built for you in Excel, you can take the guesswork out and dive right into this holistic budgeting process and integrated view that will make budgeting easier, more transparent and efficient.
When You Need Help with Financial Modeling
Financial modeling is critical for forecasting, cash management and making informed financial decisions. But planning for every scenario while managing the daily operations of your growing business can be daunting and time-consuming. Work with experts so you have the information necessary to make strategic financial decisions.
Keene Advisors is a full-service financial advisory and investment banking firm with over $40 billion in successful mergers and acquisitions, capital raising, and restructuring advisory transactions. We are dedicated to transparent communication and seamless guidance throughout every stage of the M&A process, always aiming to align short-term needs with long-term goals.
Contact us today to learn more about how we can help you with a dynamic three-statement budget model that works for you and your business.