The 3 statement modeling is a financial modeling technique used to create a comprehensive financial model of a company. It involves building projections for a company’s income statement, balance sheet, and cash flow statement over a period of time, typically 3 to 5 years.
The income statement projects a company’s revenues, costs, and expenses, and shows the company’s profitability. The balance sheet projects a company’s assets, liabilities, and equity, and shows the company’s financial position. The cash flow statement projects a company’s cash inflows and outflows, and shows how the company is generating and using cash.
The modeling technique is used in a variety of contexts i.e., corporate finance, investment banking, and financial analysis. It is often used to forecast a company’s financial performance, to assess the feasibility of a business plan, or to evaluate the potential returns of an investment.
To build a 3 statement model, one needs to gather financial data for the company, including historical financial statements, industry benchmarks, and any other relevant information. It’s also prudent to make assumptions about the company’s future performance, including factors such as revenue growth, cost of goods sold, operating expenses, and capital expenditures. Using these inputs, one can build projections for each of the three financial statements and use them to calculate key metrics such as net income, return on investment, and cash flow.
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Why Accurate Financial Projections are Prudent
Planning and Decision-Making:Financial projections help companies plan for the future and make informed decisions. By projecting future financial results, companies can determine the resources they need to allocate to different activities and investments, and adjust their plans accordingly.Raising Capital:Accurate financial projections are often required when a company is seeking to raise capital. Investors, lenders, and other stakeholders want to see a company’s future financial prospects and the basis for their projections.Managing Risk:Financial projections help companies identify and manage financial risks. By projecting future financial results, companies can identify potential challenges and adjust their plans accordingly.Monitoring Progress:Financial projections provide a benchmark for companies to track their progress towards their financial goals. By regularly comparing actual results to projections, companies can identify trends and make adjustments to their plans as needed.Allocating Resources:Financial projections help companies allocate their resources effectively. By projecting future financial results, companies can determine the resources they need to allocate to different activities and investments, and adjust their plans accordingly.
How to create a 3-statement model
- Gather Data: Gather the latest financial statements and other relevant data for the company. This may include the balance sheet, income statement, cash flow statement, as well as data on sales, expenses, and other financial metrics.
- Build the Balance Sheet: The balance sheet provides a snapshot of a company’s financial position at a specific point in time. To create the balance sheet, start by listing the company’s assets, liabilities, and equity in the appropriate categories.
- Build the Income Statement: The income statement shows the company’s revenues, expenses, and profit over a specific period of time. To create the income statement, start by listing the company’s revenues and subtracting its expenses to arrive at its net income.
- Build the Cash Flow Statement: The cash flow statement provides information on a company’s inflows and outflows of cash over a specific period of time. To create the cash flow statement, start by listing the company’s cash inflows, such as operating activities and investments, and subtracting its cash outflows, such as financing activities and investments.
- Forecast Future Financial Results: The 3-statement model is often used to forecast future financial results, based on past performance and current trends. To do this, use a spreadsheet program, such as Excel, to create projections for key metrics such as sales, expenses, and cash flows.
- Validate and Test the Model: Once the model is complete, validate and test the model to ensure that it is accurate and provides meaningful results. This may involve reviewing the assumptions and projections, comparing the results to actual financial data, and making adjustments as needed.
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It would also be necessary to create a supporting schedule for Property Plant & Equipment (PP&E) and Retained Earnings.
PP&E: Net Property, Plant, and Equipment (PPE) is calculated as the total cost of PPE less accumulated depreciation.
Formula: Net PPE = Total Cost of PPE - Accumulated Depreciation
The total cost of PPE refers to the original cost of acquiring the assets, including any related expenses such as installation, transportation, and testing.
Accumulated depreciation refers to the total amount of depreciation expense that has been recorded over the useful life of the asset. It represents the reduction in the value of the asset due to wear and tear, obsolescence, or other factors.
The net PPE at the end of a period is the balance of PPE after taking into account any additions, disposals, or depreciation during that period. It reflects the estimated value of the company’s long-term assets after accounting for their depreciation. Retained Earnings: Retained earnings are the portion of a company’s net income that is not paid out as dividends to shareholders, but is instead kept by the company to be reinvested in the business or to pay off debt.
Formula: Retained Earnings = Beginning Retained Earnings + Net Income - Dividends Paid
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Beginning Retained Earnings is the balance of retained earnings at the beginning of a period.
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Net Income is the company’s total revenue minus its total expenses for a period.
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Dividends Paid represents the amount of dividends that the company has paid out to its shareholders during the period.
Working Capital:
Another important line to consider is the working capital which is useful in calculating cash flow from operating activities.
Working capital is calculated as the difference between a company’s current assets and its current liabilities.
Formula: Working Capital = Current Assets - Current Liabilities
Current assets include items such as cash, accounts receivable, inventory, and marketable securities that are expected to be converted into cash within a year.
Current liabilities include items such as accounts payable, short-term debt, and any other obligations that are due to be paid within a year.
A positive working capital means a company has enough short-term assets to cover its short-term liabilities, indicating good financial health. A negative working capital, on the other hand, means a company has more short-term liabilities than assets and may struggle to pay its bills in the near term.
Summary
The 3 statement model can be used to estimate the value of a company. This is typically done by projecting future financial performance based on historical trends, industry benchmarks, and management guidance. The projected financial statements are used to calculate key metrics such as revenue growth, operating margins, and free cash flow, which are used to estimate the company’s intrinsic value. The intrinsic value is then compared to the company’s current market price to determine if the stock is undervalued or overvalued. This analysis is commonly used by investors and analysts to make informed investment decisions. The 3 statement model provides a comprehensive and flexible framework for evaluating a company’s financial performance and value, and is widely used in investment research and valuation analysis.