Three Statement Financial Modeling
Three Statement Financial Modeling
Three Statement Financial Modeling
In short, historical financial raw data, and ratios calculated from them, are used as an integral part of
the process to derive forward-looking assumptions that drive financial data projections. We should start
by building a model designed to reflect that.
Also, as a reminder from the Discounted Cash Flow chapter (as well as the previous chapter), use the
mnemonic C.V.S. to avoid common errors and help ensure that the outputs of your model will be
reasonable:
Numeric Display
The presentation of the financial statements can be in either a positive-only, or positive/negative,
perspective. In other words, numbers that subtract from others (such as Expense items, which subtract
from Revenue on the path to calculating Net Income) can be displayed either as positive numbers that
are subtracted, or negative numbers that are added. Mathematically, they are equivalent.
Because we already went into detail on Steps 1-3 in this process in Chapter 7, we will be expanding on
those steps in this chapter. For more detail on Steps 1-3, please revisit that chapter on the Introduction
to Financial Modeling.
Step 1: Input Historical Financial Data
The first step in building a financial operating model is to input the historical Financial Statements
(Income Statement and Balance Sheet).
Color-code your cells so that formulas are a different color from the directly input data.
Standard practice is to make the text color blue for input data and black for formulas.
Put any comments about the line items to the side of each item; standard practice is to make
comments italic.
Use the Alt + = shortcut to subtotal the income statement sections. For example, once you
input the Operating Expenses items, type Alt + = in the cell directly underneath to calculate
the subtotal for 2003 of $23,500.
Double-check that the input data correctly matches the source, and that you end up with the
same net income each year as the historical input source. You can code this as a Balance
Check formula directly in the spreadsheet.
Follow the same steps for the Balance Sheet by making sure that the input data and formulas
match the source. Also, run a balance check to make sure the data your input Balance
Sheets actually balance. For the Balance Sheet, remember the all-important Accounting
Identity: Total Assets = Total Liabilities + Shareholders Equity.
Here is a list of ratios typically required, at minimum, to build out Income Statement financial
projections:
Year-over-Year Growth Rates: Income Statement
Compute these for all years in the historical financial data range, noting that growth rate calculations
can only begin in Year 2, not Year 1:
Ratio Analysis: Balance Sheet
Next, we must compute ratios on key Balance Sheet line items for each year. Many Balance Sheet
ratios are expressed either in terms of units of time (Days), or frequency per unit of time (Turns).
Here, we have expressed these ratios as units of time (Days):
The use of these historical financial ratios will help you make your assumptions to the financial
projections in the future years of the operating model. In this way, you will be able to spot relevant
trends in these keys ratios when you project them, and help you reconcile results from the past with
the results you are projecting.
Step 3: Assumptions & Forecasts
The next step includes building out the projected years (Years 4 to 6) by making assumptions based
on the historical data. Typically, you should either use the historical ratios themselves or, where
prudent, make assumptions about how these ratios will change over time. To start, lets look at
assumptions for the Income Statement:
Here are key notes about the assumptions made in red. Please note, for the following discussion, that
Sales and Revenue are synonymous:
Year-over-Year Growth Rate Assumptions
Revenue: The company grew by very high rates in Years 2 and 3. We therefore assume that
revenue growth will slow down in upcoming years, but still be strong. The 25%, 15% and 10%
are independent variables, or assumptions they drive the models revenue projections,
rather than being calculated from revenue. To calculate Year 4 Revenue, we simply take (1 +
25%) x Year 3 Revenue. If this formula is built correctly, we can copy the formula for each year
following.
COGS: When a company grows, it is standard to assume that, all other things being equal;
Gross Margin will improve (that is, COGS as a percentage of Revenue will decline). The
reason for this, as discussed in the previous chapter, is operating leverage. Typically, we
assume an incremental improvement each year, such as a 1% decline in COGS as a
percentage of Sales. To calculate Year 4 COGS/Sales, we simply take Year 3 COGS/Sales
and subtract 1%. Then, Year 4 COGS = (Year 4 COGS/Sales Assumption Year 4 Sales),
where Year 4 COGS/Sales Assumption = (Year 3 COGS/Sales) 1%. We then subtract 1%
each year from COGS/Sales in Years 5 and 6 and copy the COGS formula over. In this way,
we are modeling a 1% incremental improvement in Gross Margin each year.
R&D: Again, we can keep R&D/Sales constant, or use an incremental improvement number
each year. Here, we have assumed a 0.5% annual reduction in R&D as a percentage of
Sales. To calculate Year 4 R&D/Sales, we take Year 3 R&D/Sales and subtract 0.5%. Then,
Year 4 R&D Expense = (Year 4 R&D/Sales Assumption Year 4 Sales), where Year 4
R&D/Sales Assumption = (Year 3 R&D/Sales) 0.5%. We then subtract 0.5% each year from
R&D/Sales in Years 5 and 6 and copy the R&D Expenses formula over. In this way, we are
modeling a 0.5% incremental reduction in R&D Expenditures as a percentage of Sales in
each year.
SG&A: These forward-looking ratios are modeled exactly the same way. In this model, we
have assumed 0.5% annual reductions in both Sales & Marketing (S&M) and General &
Administrative (G&A) as a percentage of Sales, thereby reducing total SG&A Expenses as a
percentage of Sales by 1% in each year.
D&A: For Depreciation and Amortization, we make the simplifying assumption that D&A will
remain constant as a percentage of Sales. (A more in-depth operating model would forecast
Capital Expenditures (CapEx) in each year, and then make assumptions about how much
each years CapEx would be depreciated in subsequent years.) To calculate this simple
version, take the average D&A of Years 1 through 3 (5.4% of Sales) and keep that ratio
constant going forward. In modeling D&A this way, we assume that D&A expenses will
increase as a constant percentage of Sales, and therefore grow by the same annual
percentage that Revenue grows.
Tax Rate: Typically we estimate historical tax rates and project them as a constant
percentage going forward. However, sometimes we can project that tax rates will change, for
any of a number of reasons. To illustrate this concept, in this model weve kept the Year 3 Tax
Rate (as a percentage of Earnings Before Tax, or EBT) of 33% constant in Year 4, but have
reduced it to 30% in Years 5 and 6. We might model it this way if we knew that favorable tax
treatment was coming a year down the line, perhaps from a business shift to lower-taxation
markets, or an anticipated change in statutory tax rates.
Once the key Income Statement assumptions have been made, we can build out the income
statement line items as described to compute projected Income Statement results all the way down to
Net Income, with one important exception (for now). We leave the Net Interest Income (Expense) line
item empty, which we will only link into the model as a last step. This is because Net Interest
Expense links to the other financial statements, which creates circular calculation dependencies in the
model (in a nutshell, circular dependencies occur when A is used to calculate B, which is used to
calculate C, which is then used to calculate A). If we make a mistake in this link, it can cause a serious
error in the spreadsheet, which can become very difficult to fix. Therefore, in the EBT line item, add the
Net Interest Income (Expense) line item to the Operating Income (EBIT), but leave the Net Interest
Income (Expense) line item completely blank at first. We will link it into the final model later.
Next, lets move on to assumptions used to drive projections in the Balance Sheet:
Here are keynotes about the assumptions made in red. Because Balance Sheet ratios are typically
more difficult to project, we often refrain from changing the assumptions driving these financial results,
and instead defer to historical results. Also these assumptions tend to have less of an impact on
Valuation results than do Income Statement assumptions. Please note in this discussion that Sales
and Revenue are synonymous:
Balance Sheet Ratio Assumptions
Accounts Receivable Days: Take the average of Accounts Receivable Days from Years 1
through 3, which is 28 days, and keep that number constant in the forecasted years. We can
also make assumptions about changes in this ratio if we want, but for the purposes of this
model, we have assumed that the ratio stays constant.
Inventory Days: Take the average of Inventory Days from Years 1 through 3, which are 27
days, and keep that number constant in the forecasted years. (Again, we can add increments
or decrements to this number in future years if we feel it is appropriate.)
Prepaid Expenses: Take the average of Prepaid Expenses/Sales from Years 1 through 3,
which are 1.7%, and keep that percentage constant in the forecasted years. (Again, we can
add increments or decrements to this number in future years if we feel it is appropriate.)
Days Accounts Payable: Take the average of Accounts Payable from Years 1 through 3,
which is 51 days, and keep that number constant in the forecasted years. (Again, we can add
increments or decrements to this number in future years if we feel it is appropriate.)
Accrued Expenses: Take the average of Accrued Expenses/Sales from Years 1 through 3,
which are 8%, and keep that percentage constant in the forecasted years. (Again, we can add
increments or decrements to this number in future years if we feel it is appropriate.)
Once we have created the Balance Sheet assumptions, we can fill in the Balance Sheet line items
while leaving out the Cash, Net PP&E, Debt and Shareholders Equity line items. We will derive those
Balance Sheet line items later, from the Statement of Cash Flows.
Use the following formulas to build out the relevant Balance Sheet line items:
Accounts Receivable: (Year 4 Accounts Receivable Days Year 4 Sales) 365 days
Inventory: (Year 4 Inventory Days Year 4 COGS) 365 days
The first line item in the SCF is Net Income from the Income Statement. From this, we take into
account all differences between Net Income and the change in the companys Cash position. There
are manyhere are the summary points:
Depreciation and Amortization are generally part of COGS, but they are never actually Cash
expendituresthey represent a portion of Capital Expenditures from the past that are being
recognized as expenses in the current year. Since they are expenditures in the current year
that are not paid for as Cash in the current year, they must be added back to Net Income to
account for a companys change in Cash.
When the line items of operating assets (things like Accounts Receivable and Inventory)
increase, Cash will go down on the SCF. This is because the company has, in effect, spent
Cash to build an asset, but hasnt yet received the Cash back from these assets. For
example, from Year 3 to Year 4, the Accounts Receivable line item increases by $16,131;
therefore the SCF shows a negative amount of $16,131the difference between Year 3
Accounts Receivable and Year 4 Accounts Receivable.
When the line items of operating liabilities (things like Accounts Payable and Accrued
Expenses) increase, the opposite happensCash will go up on the SCF. This is because the
company has, in effect, earned and recorded income from its operations, and thereby accrued
liabilities, but hasnt paid off those liabilities in Cash yet. For example, from Year 3 to Year 4,
the Accounts Payable line item increases by $15,792; therefore the SCF shows a positive
amount of $15,792the difference between Year 3 Accounts Payable and Year 4 Accounts
Payable.
Capital Expenditures and Depreciation will dictate the change in Net PP&E. For example,
Year 4 Net PP&E = Year 3 Net PP&E + Year 4 Capital Expenditures Year 4 Depreciation.
(Note that in this model, Capital Expenditures have been manually input in the SCF each year,
as negative numbers, because they constitute a use of Cash that is not yet reflected in the
Income Statement.)
Net Income and Dividends will dictate the change of Retained Earnings on the Balance Sheet.
For example, Year 4 Retained Earnings = Year 3 Retained Earnings + Year 4 Net Income
Year 4 Dividends. (Note that in this model, Shareholders Equity is modeled as a single line
item in the Balance Sheet therefore the change in Retained Earnings will be reflected in the
change in Shareholders Equity.)
Debt Issuances/(Repayments) can be placed in the cells highlighted in blue based on your
assumptions about future changes in debt levels. The same holds for Stock Issuances/
(Buybacks). In each case, these Cash inflows/outflows are financing-related, rather than
operations-related, and therefore will not be reflected whatsoever in the Net Income
calculation. However, they will result in changes to a companys Cash balance, and therefore
must be recorded in the SCF.
The companys Change in Cash will equal the sum of the Change in Cash from Operating,
Investing and Financing activities. For example, Year 4 Ending Cash Balance = Year 3 Ending
Cash Balance + Year 4 Cash from Operations + Year 4 Cash from Investing Activities + Year 4
Cash from Financing Activities.
3.
4.
Calculate Net PP&E as Year Prior PP&E + Capital Expenditures (from the SCF)
Depreciation (from the SCF).
Calculate Long-Term Debt as Year Prior Long-Term Debt + Issuance/(Buyback) of Long-Term
Debt (from the SCF). (Note that in this model, a distinction is made between Long-Term Debt
and Short-Term Debt, and that the entire Debt balance convert from Long-Term Debt to ShortTerm Debt in Year 5 before being repaid in Year 6.)
Calculate Shareholders Equity as Year Prior Shareholders Equity + Issuance/(Buyback) of
Stock (from the SCF) + Current Year Net Income Current Year Dividends (from the SCF).
(Note that in this model, no Dividends were modeled in the SCF, so the assumed Dividends
payment to Shareholders in each year equals $0.)
Link the Beginning Cash Balance and Ending Cash Balance formulas between the SCF and
the Balance Sheet. For example, in Year 4, the Beginning Cash Balance in the SCF should be
set equal to the Cash line item for Year 3 on the Balance Sheet. The Cash line item for Year 4
on the Balance Sheet should be set equal to the Year 4 Ending Cash Balance on the SCF.
Follow this logic for all years in the financial model. Once you have linked the Cash and
remaining line items such as Debt and Shareholders Equity, then the Balance Sheet should
balance (Total Assets = Total Liabilities + Shareholders Equity).
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Step 6: Interest Expense (Be careful!)
At this point the financial model should balance and all balance checks should be affirmed. We have
only one piece left to complete: calculating Net Interest Income/(Expense).
As we have discussed before, this calculation flows through all three Financial Statements in the
model in what is referred to as a circular calculation (or iterative calculation). When a circular
calculation is built, the outputs of a series of calculations become inputs into the same calculation. It is
the task of the spreadsheet software to change the values of the different components of the
calculation to find a set of values that makes all of the calculations work.
At this stage it is very easy to introduce a mistake into the calculation, and generate an error. Because
the calculations are now iterative, any such error will flow through ALL of the calculations, and the
entire model will become populated with error messages. (Many an investment banker has gone a
sleepless night trying to resolve an accidental error in a circular calculation, so be very careful!)
In order to minimize the chance that you make this mistake, follow these steps exactly:
Avoiding a Circular Calculation Error
1
2
3
4
Turn Iterations in the workbook OFF. This can be done through the following Excel menu
command: Tools Options Calculations.
Check every formula and make sure the Balance Sheet balances in each projection year.
Save your workbook. If the following steps introduce an error into your workbook, you
should strongly consider closing it without saving it, and re-opening the saved version.
Calculate Net Interest Income/(Expense) for the first projection year in your model. In the
example in this chapter, this would be Year 4. Net Interest Income/(Expense) is calculated as
follows:
If you have built this formula correctly, Excel should complain. It will introduce a dialog box
informing you that the calculation is circular. When that box is closed, it will likely open a Help
file explaining iterative formulas to you. Close both of these boxes and return to the
spreadsheet.
6 Turn Iterations in the workbook BACK ON. This can be done through the following Excel
menu command: Tools Options Calculations.
7 If you have computed this correctly, Net Income should have increased/(decreased) by the
Net Interest Income/(Expense) amount, and several Balance Sheet items should change
slightly (both in the current year and in future years).
8 Check every formula and make sure Balance Sheet for the first projection year still balances.
9 If everything still looks good, copy the Net Interest Income/(Expense) formula from the first
projection year into the remaining, future projection years. Once again, make sure no errors
get introduced, and check to make sure the Balance Sheet still balances in all years. (If an
error gets introduced, strongly consider closing it without saving it, and trying again with the
saved file.)
10 If your Balance Sheet still balances and the Interest calculations appear correct, then
SUCCESS!
Final Checklist
Congratulations you are done building your integrated, three-statement financial model! Here are just
a few things to consider and check before considering the model 100% complete.
Never hardcode any number in a formula. Check formula cells to make sure there are no
hardcoded values or assumptions in them.
Make sure that, where applicable, assumptions are the first inputs in each calculation formula.
Check to see if the trend of each important line item is gradually increasing or decreasing
rather than exponentially increasing or decreasing. If you have exponential patterns, you
should probably change the assumptions driving them.
Insert any relevant comments (you can use the shortcut Shift + F2) to help other teammates
understand your model and assumptions.
Press Ctrl + Home on each worksheet in the Excel workbook so that cursor is on cell A1 in
each sheet, before sending the model to your teammates.