Three Statement Financial Model Guide

The key phrase there is accurate and timely. The traditional method of building a three statement model in a manual excel spreadsheet opens up the potential for errors or mistakes, as well as taking up valuable time in building and updating it manually.

These days, there’s no need to do that, with modern financial modeling software solutions providing finance teams with access to all the components of the three financial statements at their fingertips. All calculated in real time, using financial data that is automatically collated without any need for human intervention.

Not only does this make the finance professional role more efficient, but it can help improve a company’s valuation and the success of their financing activities.

Here’s how the three statement financial model works, and how modern finance teams can use it to effectively drive their strategic decision making, beyond simple Excel models.

What is a Three Statement Financial Model?

A 3-statement model is a model that produces three key financial statements: the income statement, the balance sheet, and the cash flow statement.

This model provides a complete picture of a company’s financial health and forecasts the expected future financial performance and its impact on the company balance sheet. The three individual components of the model each play a different role in projecting the future financial position of the company.

The 3-statement financial model can also serve as the basis for further financial models, such as the discounted cashflow model (DCF model).

Income Statement

The first component of the three statement financial model is the income statement (also known as the P&L statement). It provides a summary of the line items in the company’s revenue, expenses, and profits over a specific period.

Unlike the cash flow statement, the income statement is created using accrual accounting, meaning it reports revenue and expenses based on when they’re earned and incurred, rather than when the cash is received.

It also includes non-cash items such as depreciation.

Balance Sheet

The balance sheet provides an overview of a company’s financial position at a specific point in time. This includes its assets, both current and noncurrent, its liabilities, both current and noncurrent, and its equity.

The 3-statement model looks to forecast how the balance sheet will change as a result of the income and cash flow projections.

Cash Flow Statement

The final component of the three statement financial model is the cash flow statement, which shows the company’s cash inflows and outflows over a period.

Importantly, this statement has nothing to with when the income was earned by the company. For example, revenue that was reported in the income statement in a previous quarter or previous year, may not be actually paid during the same period. It may show up in the cash flow statements months, or even years, later. Financial analysts need to forecast this separately to predict and manage the liquidity position over time.

Building Your Model: A Step-by-Step Guide

The three statement model serves as the foundation for your financial forecast. Traditionally this would involve a substantial amount of manual calculations and data gathering.

Using Mosaic, finance teams have the ability to create all three components of the 3-statement model at the click of a button. This pulls real time data to automatically calculate your financial position, allowing you to focus on the future.

With that in mind, let us walk you through forecasting revenue, budgeting expenses, modeling the balance sheet, and the cash flow statement.

Forecast Revenue

To project revenue accurately, start with the historical revenue growth trends to establish a baseline.

You can use this historical data to forecast future revenue, adjusting for market conditions, competitive landscape, and company strategy.

Companies also need to account for churn by calculating historical churn, and estimating future rates based on industry benchmarks and customer retention strategies.

All of this can be done directly on the Mosaic platform, allowing finance teams to identify and assess a wide range of accurate, real time data in a short space of time.

Budget Expenses

The next step in building the financial model is to accurately forecast operational expenses such as cost of goods sold (COGS) and labor costs.

Headcount is likely to be the largest category in the budget for both SaaS and professional services companies. As a result, headcount planning should be the first step in building a budget for the coming year.

Mosaic provides detailed headcount planning tools, allowing finance teams to create categories and seniority levels for every type of employee, which can then flow directly into the financial mode.

Sales and marketing will be another sizable expense, and teams can analyze previous expenses and their efficiency in acquiring new customers to help estimate future expenses. Determining the customer acquisition cost (CAC) and the number of new customers targeted will provide the appropriate context to consider how these costs will scale with revenue growth.

Research and development (R&D) expenses may be an important cost for SaaS companies while professional services firms may have little to none. As with other costs, financial analysts should assess historical financial statements and strategic forward planning to guide their projections. The tax treatment of this expense is also important to model correctly.

Model the Balance Sheet

With the revenue and budget forecast complete, it’s now time to forecast the balance sheet.

Forecasting the balance sheet involves projecting assets (including cash balances), liabilities, and shareholders’ equity. For assets, you need to project both current assets like cash and accounts receivable based on revenue growth and operating activities, and non-current assets such as capital expenditures (CapEx).

For liabilities, estimate current liabilities like accounts payable and accrued interest expenses in line with your expense projections. For long-term liabilities, consider repayment schedules and any additional planned borrowings.

Equity projections should include calculating retained earnings by adding net income and subtracting dividends, as well as including any planned equity financing.

Model the Cash Flow Statement

The cash flow statement forecast can be built using the income statement and balance sheet. We start with forecasting cash flow from operating activities. Take the net income from the income statement, adjust for non-cash expenses like depreciation and amortization, and account for changes in working capital such as accounts receivable and accounts payable.

For investing activities, subtract any cash spent on capital expenditures and include cash flows from the purchase and sale of investments. In financing activities, add cash inflows from new borrowings or equity financing and subtract cash outflows for debt schedule repayment and dividends.

Some assumptions need to be made on the timing between the P&L statement and the cash flow statement, but Mosaic provides detailed historical data on metrics such as days sales outstanding which can help guide these.

Best Practices for Financial Modeling

One of the most effective ways finance teams can ensure they’re creating a useful and accurate financial model is by using the right strategic finance software. Connecting real-time data, leveraging AI and machine learning functionality, and automating components of the forecasting process means a more efficient process with less room for error.

Software integration ensures that your model remains up-to-date and responsive to new information, allowing finance teams to iterate and amend their financial plan quickly.

Scenario Analysis and Sensitivity Testing

Scenario analysis and sensitivity testing are essential tools in financial modeling. These techniques help you understand the financial impact of different strategic choices, or model scenarios based on a range of economic or sector specific performance outcomes.

By creating multiple scenarios you can gauge how changes in key drivers like customer acquisition costs, churn rates, win rates and pricing strategies affect your financial projections. This can help you use cash flow analysis to build a more robust plan to maximize profitability, through all market conditions.

Sensitivity analysis, on the other hand, involves adjusting one variable at a time to see how sensitive your model is to changes in that particular factor. This helps in identifying which metrics or assumptions have the biggest impact on your financial outcomes. This can assist with strategic planning, but also with resource management when creating your budget and headcount plan.

Maintaining Flexibility and Scalability

The only thing that’s certain about a financial model is that it is almost certainly not going to be correct down to the last dollar. The role of finance is to get the projections as close as possible to the actual outcome, but maintaining flexibility and scalability is vital.

A financial model needs to be a living document, not a once a year project that gets shelved for the next 12 months.

Finance teams need to regularly review and update assumptions to reflect the latest business conditions and strategic goals. This can be a challenge for teams using traditional forecasting methods such as Excel spreadsheets.

While it is possible to build a model using dynamic formulas and data aggregation techniques, modern finance platforms offer a huge advantage. By connecting real-time data sources to the model, and offering AI and machine learning tools to help forecast the data, a model can be updated automatically.

This improves accuracy and decreases the need for manual data entry, freeing up financial analysts to work on the ‘why’ of a changing landscape, rather than spending hours on the ‘what.’

Conclusion: Empowering Your Business with Financial Insights

The three-statement financial model is the cornerstone of a finance team’s work. By integrating the income statement, balance sheet, and cash flow statement, this model provides a detailed overview of your company’s financial health, while offering insights on operational efficiency and providing a baseline for forward projections.

When using software like Mosaic, finance teams have access to their three financial statements at any time, which are automatically kept up to date using real time data.

This means faster and more accurate assessment of your company’s current financial position, as well as sophisticated financial forecasting and scenario planning tools.

Coupled with AI and machine learning features, Mosaic gives finance teams the ability to analyze, forecast and strategize on their data in a way that allows them to become a true strategic partner to the company.