The 3-statement model is often seen as the key building block of all financial forecasting and valuation in corporate finance and investment banking. If you have to build a pitch deck, run a cash runway for your startup or do an analysis on potential acquisition this model has to be built right, no exceptions.
This blog outlines the steps to create an integrated 3 statement model, aligns it with best practices for building financial models, and begins to demonstrate how to use it in creating a valuation model and a long term forecast.
What Is a 3-Statement Model?
The 3-statement model is a fully integrated financial model that combines a company’s:
- Income statement
- Balance sheet
- Cash flow statement
Without formulas to link the three statements dynamically, any changes in one statement would have to be updated in each of the others manually.
Flexibility brings together data from numerous sources into single repository, allowing finance professionals to use the same trusted data while simulating business scenarios and testing valuation models.
What is a 3-Statement Model?
A 3-statement model has a lot of critical uses:
- It is the foundation of many valuation models such as DCF (Discounted Cash Flow) and LBO (Leveraged Buyout).
- It provides stakeholders with a transparent and comprehensive look at business health and future performance.
- This is often used as an essential tool for strategic planning, mergers & acquisitions, as well as investor presentations.
In other words, it is the default format of financial due diligence.
How to Create a 3-Statement Model: Step-By-Step
Here’s how you can create a 3-statement model:
Step 1: Collect the Historical Financial Information
First, gather historical income statements, balance sheets, and cash flow statements—ideally for the last 3 to 5 years. This data provides the baseline to help forecast and assess what a reasonable assumption is.
Key Components:
- Revenue and expenses (COGS, SG&A)
- Working capital items
- CapEx and depreciation
- Own funds, loans, and undistributed profits
Therefore, this knowledge is the basis of forward predictions.
Step-2: Construct the Profit & Loss statement
The income statement (or profit and loss statement) summarises the performance of the company, typically over some time.
Structure:
- Revenue (top-line)
- Less: Cost of Goods Sold (COGS)
- = Gross Profit
- Less: Operating Expenses (SG&A, R&D, etc.)
- = EBIT (Operating Profit)
- Less: Interest & Taxes
- = Net Income
Emphasise on metrics such as revenue growth rates, gross margins, and ratios of operating expense to revenue. These assumptions will seep into your financial model of the future.
Step 3: Produce the Balance Sheet
A balance sheet is a statement of the company showing its assets, liabilities, and equity at a specific moment in time.
Assets:
- Working capital (Cash, Accounts receivable, Inventory)
- NON-CURRENT (PP&E, Intangible Assets)
Liabilities:
- Current (Accounts Payable, Accrued Expenses)
- Long-Term Debt
Shareholder’s Equity:
- Common Stock
- Retained Earnings
Balance sheet items are frequently related to operating metrics. For instance:
- That means, Accounts Receivable = Revenue x DSO / 365
- Which, after rearranging is called: Inventory = COGS x days of inventory outstanding (DIO) / 365
Step 4: Build the cashflow statement.
And this balance sheet cash flow relationship is key because it brings everything back together. Cash flow is divided into three section:
- Operating Activities – This section begins with net income and then adds or subtracts from it the non-cash items (like depreciation) and the changes in working capital.
- Investing Activities – Consists of capital expenditures and sales of assets
- Financing Activities – Shows debt issued/paid back and equity movements.
Ensure your cash flow statement reconciles with both the income statement and balance sheet, forming a closed-loop system.
Best Practices on How to Link the 3 Statements
A 3-statement model is a series of inter-connected statements that flow logically and mathematically between each statement.
- Retained earnings and cash = Net income
Net income from the income statement ends up in retained earnings on the balance sheet and at the starting point of cash flow from operations.
- Depreciation and CapEx Affects on Many Fronts
The net income is reduced by depreciation (non-cash as well), which leads to a reduction in the balance of the assets and cash flow.
- CapEx is closely related to cash and enhances fixed asset base.
- Quick Recap About How Working Capital Connects the Three Statements
- An increase in current assets (such as Inventory) leads to a reduction of cash.
- Cash is increased by increases in current liabilities (e.g., accounts payable).
Realisation of these changes get reflected as cash flow changes impacting cash carry forward.
Best Practices for Financial Models
Achieving accuracy and transparency are key when developing a model. These are best practices for financial modelling:
Display simple and uniform formatting
- For example: Blue for input cells (assumptions), Black for formulas.
- Input sections differ from areas where calculations occur.
Maintain Model Hygiene
- Use version control
- Use descriptive names for sheets and ranges
- Implement Excel best practices (such as avoid hard coding, create traceable formulas)
Test Model Integrity
- Do use of error checks: e.g., a balance sheet must balance.
- Have sanity checks on growth rates and margins and ratios built in
Keep it Modular
Dividing your model into logical segments – revenue, expenditure, depreciation, working capital, financing – creates an opportunity for you to be able to unit test each area and debug in isolation.
Use Dynamic Formulas
Avoid hardcoding unless absolutely necessary. Use Excel functions like IFERROR(), MIN(), and INDEX/MATCH to make your model robust and adaptable.
Adding Projections: Creating Logic for the Future
When you have your historical statements properly integrated, stretch the model out so that you can project 3–5 years into the future.
Forecast Key Drivers:
- Revenue Growth Rate
- Gross Margin %
- SG&A as % of Revenue
- CapEx and Depreciation
- Working Capital ratios
These forecast assumptions must be customisable as per logic of scenario (i.e. base, optimistic, and pessimistic etc.)
Sensitivity Analysis Automated
If you want to test how different levels of sales volume or cost inflation would affect your model, include sensitivity toggles and charts. Better decisions means more investor confidence.
Building a Valuation Model Off of the 3-Statement Model
Once you have a working 3-statement model, it can be used for a variety of different valuation methods:
DCF (Discounted Cash Flow)
Calculate intrinsic value using free cash flow from cash flow statement with WACC as a discount factor
Comparable and Precedent Transactions
Utilise EBITDA, revenue, and net income figures from your income statement to derive pertinent market multiples.
Terminal Value
Find the long-term value of the business after the explicit forecast period using a perpetual growth rate or exit multiple.
Common Mistakes to Avoid
❌ Failing to Link All Three Statements
Make sure any change in net income, depreciation or working capital filters through all three statements correctly.
❌ Over-Hardcoding
A few hardcoded values are needed (tax rates, for instance), but too many renders the models inflexible and error prone.
❌ Bypassing Cash Balance Reconciliation
Closing cash position should reconcile cash flow statement with balance sheet cash flow section Otherwise, the model is busted.
❌ Invalidated Assumptions
Base your forecast assumptions in logic or genesis, not scatter-shot guesses.
Final Thoughts
Constructing a 3-statement model is an indispensable skill for anyone in finance, accounting, or entrepreneurship. Through the application of financial model best practices, the validation of your links, and a transparent approach to projections, you should have not only a functional tool but a strategic one as well.
Whether to plan internally or pitch for external investments, a clean 3-statement model forms the foundation for any serious valuation model, and provides stakeholders with clarity, confidence and control over financial decisions.
FAQs
What is included in a 3-statement model?
A 3-statement model consists of an income statement, balance sheet, and cash flow statement that are interconnected. It gives a broad view of a company’s financial situation, flows net income into retained earnings and cash, and solving dynamic balance equation for assets, liabilities and equity.
What is a 3 statement model, and why is it important for financial forecasting and valuation?
It is a basis for all sound valuation models like DCF or LBO. Connecting the three statements makes sure financial projections are synchronised, traceable and reliable — a must-have for scenario planning, investor assessment and capital budgeting.
What are financial model best practices I should follow?
Some key financial model best practices include:
- Highlighting inputs and formulas by colour-code
- Do not hardcode if you can help it
- Error checks and balance sheet validations
- Keeping your model modular, easier to audit
How do you forecast in a 3-statement model?
Forecasts are based on assumptions about how revenue will grow and where margins, operating costs, CapEx and working capital are likely to land. Those assumptions are entered and run through the income statement, balance sheet, and cash flow, allowing dynamic run-out of the future.
Can I use a 3-statement model to value a startup or small business?
Yes, a solid 3-statement model is important for startups too. It enables forecasting performance, controlling burn rate, and creating a defensible valuation model for your future fundraising. While it may not have long history to draw from, realistic driver-based projections lend credence to the proposition to investors.
