Financial modelling is a key component of understanding a company’s past performance, predicting its future potential, and supporting milestone events such as fundraising, expansion, or M&A. The 3-statement financial model is among this area’s most fundamental and widely utilised models. The purpose of this blog is to provide a step-by-step guide to what it is, how it works, and why every serious business owner, analyst, or investor should know about it.
Or the full Three-Statement Financial Model Structure, assuming you want to check out the entire Financial Modelling Guide, which de-mystifies the three-statement model structure and teaches how the different financial statements link together for a complete view of a company’s financials at the portmanteau of a brief click.
What Is the 3-Statement Financial Model?
The 3-statement financial model is an interconnected model that provides an integrated view of a company in a single Excel spreadsheet with an income statement, balance sheet, and cash flow statement. This enables users to project future performance considering historical trends and a set of assumptions, reducing uncertainties in the decision-making process for stakeholders.
In other words, the Financial Model Breakdown is the foundation for more sophisticated valuation methods discounted cash flow (DCF) analysis, merger models, and leveraged buyouts (LBOs).
Why Is the 3-Statement Model So Important?
Here are a few of the reasons this model is considered the gold standard when it comes to financial analysis:
- Forecasting precision: Connecting the three statements is one way to promote consistency in the projections.
- Scenario analysis: It allows you to simulate various business scenarios and evaluate the complete financial impact.
- Base for valuation: It establishes the foundation for the valuation of equity and capital budgeting decisions.
- Internal budgeting: Businesses use it to prepare operating budgets and plan for capital expenditures.
When it comes to building a business plan or creating investor presentations, knowing how to understand and build the 3 statement model is an unsung hero.
Let’s Break Down Each Statement
When building a model, we need to first know the flows that the model connects: the income statement, balance sheet, and cash flow statement.
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Income Statement
The income statement, or profit and loss (P&L) statement, outlines a company’s revenues, expenses, and profits over a time period (which can be monthly, quarterly, or yearly).
It also makes answering the question easier: Is the company generating a profit?
Key components include:
- Revenue (top line)
- Cost of Goods Sold (COGS)
- Gross Profit
- Selling, General & Administrative Expense and Research and Development Expense
- Operating Income (EBIT)
- Interest and Taxes
- Net Income
Net income at the very bottom of the income statement is important it is a direct link to the cash flow statement (as the starting point of operations) and also to the balance sheet (as part of retained earnings).
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Balance Sheet
A balance sheet represents the company in terms of financial standing at the moment. It follows the equation:
The Accounting Identity Assets = Liabilities + Shareholders’ Equity
The statement represents the resources the company owns and how those assets are financed either through debt or equity.
Main sections include:
- Assets: Cash, accounts receivables, inventory, property, plant & equipment (PP&E) etc.
- Liabilities: Payables, expenses in line, short-term and long-term debt
- Equity: Common stock, paid-in capital in excess of par, accumulated earnings.
The balance sheet is what safeguards the fact that the financial model has to make sense it all has to add up.
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Cash Flow Statement
Although net income is one marker of profitability, it does not mark the movement of cash. That void is filled by the cash flow statement. It illustrates how much cash is produced or consumed within certain period.
That was broken down into thirds:
- Operating Activities: Cash flow statement from the simple version starts with net income, add back non-cash expenses (depreciation expense), and makes adjustment with working capital changes.
- Cash Flows from Investing Activities: Capital expenditures (CapEx), purchases of securities, or acquisitions.
- Financing Activities: It includes borrowing or repaying debt, issuing stock or dividends.
A cash flow statement reconciles an increase or decrease in a company’s cash balance between two periods with operating, investing, and financing activities.
How These Three Statements Are Linked
This is the heart of the 3-statement financial model connecting the statements together. Here is how they work together to achieve this:
- Net income in an income statement appears as the first entry in cash flow statement-operating activities section.
- In the cash flow statement, depreciation and amortisation (which appear on the income statement as a non-cash expense) are added back.
- Working capital adjustments (arising from changes in accounts receivable, inventory, payables) are computed based on balance sheet items.
- The CapEx (reflected in the cash flow statement) will result in reduced cash and increased PP&E balance at the balance sheet.
- The liabilities side of the balance sheet is impacted by the cash flow statement through the repayments/issuances of debt.
- The cash line on the balance sheet is updated with the cash flow statement ending cash balance.
The Financial Model Breakdown is complete by making these links—what occurs in one statement aggregates to the next.
Building a 3-Statement Financial Model Step-by-Step
Below is Step Wise BS Financial Modelling Guide for Beginners.
Step 1: Collect Historical Data
Starting historical financials of, at minimum, 2-3 years Income statement, balance sheet & cash flow. Make sure they reconcile.
Step 2: Input Assumptions
Project forward looking drivers such as revenue growth, margin trends, capital expenditures, and changes in working capital. These assumptions will drive the model.
Step 3: Project the income statement
Project revenue, expenses, and determine profit.
Step 4: Construct the Balance Sheet
Using your links and assumptions project out each item: cash, receivables, payables, inventory, debt & equity.
Step 5: Fill out the Cash Flow Statement
It calculates cash flow from the net income adjusting it for the non-cash items and the working capital requirements. Include cash flows from investments and financing
Step 6: Link the Statements
Make the statement relatable so that changing one reflects in others. For example, PP&E depreciation decreases net income by should be added back in cash flows.
Step 7: Validate the Model
Check that:
- Assets = Liabilities + Equity
- Cash flows reconcile
- Retained earnings are correct
Common Mistakes in 3-Statement Modelling
- Failure to properly link depreciation or interest expense
- The avoidance of circular references when interest costs are based on average debt
- Ignoring working capital adjustments
- Compounding the debt repayments is not logical
- The cash ending balance from the cash flow does not match the cash ending balance on the balance sheet
- Building an accurate 3-statement financial model is, by nature, a detailed and precise process.
Use Cases of the 3-Statement Model
Here’s how this financial model serves different decision-making requirements:
- Strategic Planning & Budgeting: Aids companies in understanding their funding, profitability and capital needs.
- Valuation Analysis: Serves as a foundational template for doing DCF or comparable company analysis
- Investor Presentations: A tidy, link model inspires confidence in your business outlook and your fiscal discipline.
- M&A Scenarios: Lets analysts model the effect of acquisitions or mergers on all main financials.
- Lender Review: This model is used by banks and lenders to determine the extent to which the debt can be serviced.
Popular Tools & Software Use
- Excel/Google Sheets – the most common platform for building these models
- Modelling plugins like Macabacus or Wall Street Prep templates
- Financial modelling courses that offer best practices for beginners and professionals alike
Excel remains dominant due to its flexibility and familiarity, especially when dealing with structured financial inputs and scenario testing.
Final Thoughts
A good 3-statement financial model is more than just an excel spreadsheet it is a tool for storytelling that communicates the future of a company via numbers. Whether you are constructing it from the ground up or analysing one that was already prepared by another, knowing how the income statement, balance sheet and cash flow interlink is fundamental to accurate, insightful and action-oriented financial planning.
We have walked through the structure, logic, inter-connections, and applications of the model in this Financial Modelling Guide. This model is one stop solution for any strategic thinking and key level decision making; be it an entrepreneur, analyst or investor.
Now, the next time someone mentions the Financial Model Breakdown, you know not only what it is but how the whole thing comes together.
FAQs
Why do you use a 3 Statement Financial Model?
This is a 3-statement model that links the income statement to balance sheet and cash flow statement to forecast an x-number of year’s forward financial performance for a company. It assists in making decisions regarding budgeting, fundraising, and business planning.
How does the cash flow statement link to the balance sheet?
The cash flow statement and balance sheet are linked through cash, and there is also an indirect relationship with other items. It means the cash number in the balance sheet gets updated with the ending cash balance from the cash flow statement so the model balances and all cash activity is modelled.
Do I need Excel to build a 3-statement model?
Excel is the most common, but tools like Google Sheets or even dedicated software such as Quantrix or financial modelling platforms can be used.
Why is it important to link all three statements?
This is done to maintain accuracy in financial forecasting and consistency. Consider, Depreciation affects all three statements; net income (reducing it) on the income statement, non-cash flow adjustments on the cash flow statement and the asset value on the balance sheet.
Where do you actually start when constructing a financial model?
Historical data for at least 2-3 years must be collected then projections of the statements are done and based on trends and business driver’s assumptions would be made.
