## Introduction

Building a financial model from scratch can be a complex and intimidating task for many. A financial model is a set of equations and assumptions built to project the financial performance of a given entity, such as a business. It can be used by investors and analysts to understand the past performance and predict the future performance of the entity and inform decisions. A three-way financial model is considered to be the most basic version of a financial model which consists of the income statement, balance sheet and cash flow statement.

This blog post aims to provide a comprehensive guide on how to build a three-way financial model from scratch, covering all aspects of the process and empowering you to create your own model. In this post, we’ll discuss the essential components of a two-way and three-way financial model. We will then provide an overview of the process of building a three-way financial model and highlight the main considerations to take into account. Lastly, we will provide a step-by-step tutorial on how to create a three-way financial model.

## Key Takeaways

• Understanding the essential components of a two-way and three-way financial model
• Overview of the process of building a three-way financial model
• Important considerations to take into account when creating your model
• Step-by-step tutorial on how to create a three-way financial model

## Understanding the Dynamics of a Three Way Model

The three-way financial model is a more complex and comprehensive type of financial model. It brings together the three underlying aspects of an organization's financial operations: revenue, expenses and cash flow. A three-way model serves as a tool for evaluating the long-term performance of a business, and helps users better quantify future scenarios and determine the best course of action for future success.

### Revenue Streams

At the core of any three way model is the revenue stream. This is a crucial component of the three way model since it frames the entire financial prediction. To calculate an accurate revenue stream for the model, the historical performance of sales must be examined and incorporated into the financial model. This includes analyzing trends in sales from month to month and from year to year in order to gain insight into any possible changes or disruptions that could affect the future financial state of the business.

### Expenses

The expenses portion of the three-way financial model is designed to give users a comprehensive look at the cost structure of a business. This analysis should go beyond the basics of operating costs and take into consideration the investments associated with growth, such as new product development, marketing campaigns, and other strategic initiatives. Also, the management of any long-term debt should be accounted for in this section. This will give the model a more thorough view of the financial health of the organization.

### Cash Flow

The last component of the three way financial model is cash flow. This section takes into account the difference between the money earned and the money spent by a business. It also takes into account any receivables or payables that may affect the cash flow in the short term. To get accurate predictions for future cash flow, businesses should take into account different payment terms for customers and suppliers. This could include any discounts, early payment incentives, or long-term contracts.

The accuracy and effectiveness of a three way model greatly depend on how meticulously each of these three components is calculated. The more thorough the analysis of these components, the more reliable the financial model's predictions will be. With the right data and analysis, a three way financial model can be an invaluable tool for future-proofing a business’s financial future.

## Preparing the Data

Once the overall financial model is planned and built, it's time to look at how to prepare the associated data. Gathering the financial statements and organizing them into concise data types is an important part of the process. With the correct data in hand, the model can be populated to start analyzing the financial situation.

### Gather Financial Statements

The basis of the analysis will come from the financial statements of the company. These statements are the financial documents the company publishes regularly and contains the necessary information for the analysis. Depending on the purpose of the model, the data may range from one year to many years. Once the financial statements are gathered, these documents should be analyzed to extract the relevant data into the model.

### Organize into Data Types

Once the financial statements are obtained, the data needs to be ordered in such a way that it can be uploaded into the model. Ordering the data by data types such as cashflow, income statement, or balance sheet allows for easy entry into the model.

### Enter Data into Model

This is the finally the step of loading all the data into the model. Depending on the level of accuracy wanted, this may involve copying and pasting each line item from the financial statements, or alternatively, only entering the important figures into the model. In either case, the data should accurately reflect the financial statements of the company.

## Building the Model

Constructing a 3 Way Financial Model from scratch requires careful planning, accuracy and attention to detail. The basic steps of the model building process are selecting a template, creating assumptions and setting cash flow projections.

### Select Template

The foremost step in the process is deciding on a template to guide you in developing the model. Begin by considering the purpose of the model, the functional use and the needs of the stakeholders. All these factors should be taken into account when selecting the appropriate template.

A 3 way financial model includes an income statement, balance sheet and cash flow statement. Therefore, it is important to make sure that these three components are included in the template. In addition, other important elements such as debt, taxes and equity should also be included. Once you have identified the elements needed to build the model, search for a suitable template that meets your project requirements.

### Create Assumptions

The second step is to create the assumptions for the model. This is the most difficult and time consuming part of the process. As assumptions are the formulation of the individual components of the model, taking care to make accurate and realistic assumptions is of utmost importance.

When constructing assumptions, begin with setting the base case scenarios and then adjust according to project specifics. Consider the historical performance and the anticipated trends of the organization against benchmarked averages available. It is important to remember that the assumptions should serve as the foundation of the model.

### Set Projections

The last step is to set the cash flow projections. A cash flow projection is a financial plan that encompasses all the financial tasks such as working capital management, financing and strategic investments. It is the basis for decisions on shareholder value, board of director allocations and operational strategies.

The cash flow projection should include all the changes reflected in the income statement and balance sheet. All assumptions should be reviewed and any discrepancies or inconsistencies should be fixed at this stage. In addition, it is important to perform a sensitivity analysis to assess the impact of varying assumptions on the cash flow projections. Lastly, the projections are presented in a graphical format that can be shared with stakeholders.

Once you have built your 3 way financial model, you will need to test it to make sure that it functions as intended. There are two primary methods for testing your model – sensitivity analysis and scenario testing – which we will discuss in detail below.

### Sensitivity Analysis

Sensitivity analysis, also known as “what-if analysis”, is a process of testing how changes to certain variables in the model will affect the overall outcome. This can be done manually, by changing the values of certain variables and recalculating the overall results, or it can be accomplished with the help of a computer. By making adjustments to key variables and recalculating the results, you can determine which variables have the most significant impact on the model’s outcome.

### Scenario Testing

Scenario testing is the practice of running simulations to determine how the model will respond to specific sets of circumstances. This can be done by running simulations that involve changing certain inputs in order to see how the results are affected, or it can be done by running simulations with various predicted outcomes to see how the model responds. By running various simulations and evaluating the results, you can gain valuable insight into how the model behaves under different conditions and can make adjustments as needed.

## Refining the Model

Creating a financial model involves a lot more than simply plugging in numbers and values – it's a careful process that requires lots of forethought and time to ensure that the end result accurately reflects a company's financial situation. As you enter values and formulas, it's important to continually review the model and rework it as needed in order to make it as effective as possible.

### Check for Errors

The first thing to do when refining a financial model is to check for errors. Are there any typos or mistakes in the existing formulas? It's easy to miss small errors – double check the details of your model to make sure that the numbers are accurate. This will ensure that the model produces reliable results. Additionally, be sure to cross-check the sources of your inputs, such as assumptions and forecasted values, to make sure they are accurate.

### Manage Model Complexity

When fine-tuning a financial model, it's important to make sure that it doesn't become too complex or unwieldy. Simplifying the model can make it easier to read and understand, and will also make it less likely to contain errors. Try to arrange the model into a logical format and group similar elements together to make it easier to navigate. Additionally, try to limit the amount of static information in the model – the more static elements you have, the harder it is to update when needed.

When refining a financial model, always remember to double-check for errors and manage model complexity in order to ensure the best possible results. With these tips in mind, you can make sure that your financial models are as effective and accurate as possible.

## Conclusion

Building a 3 Way Financial Model from scratch requires a certain level of expertise and experience. It is a complex process that needs to be undertaken carefully and methodically in order to achieve desired outcomes. The following steps provide an overview of the process: gathering data, creating assumptions, building the model, validating the assumptions and debugging the output.

Following these steps will ensure your model outputs are robust and complete. The biggest benefits of having a 3 Way Model come from its ability to help decision-makers forecast future cash flows based on current and historic factors. This is an important tool to help you gain better insights into the potential outcomes of your business decisions.

### Summary of Steps

• Gathering Data
• Creating Assumptions
• Building the Model
• Validating Assumptions
• Debugging Output

### Benefits of a 3 Way Model

The 3 Way Model offers many benefits to help you make better-informed business decisions. It can help you forecast future cash flows, anticipate shortfalls and manage financial risk. It offers insights into operational performance, provides an understanding of business dynamics and assists in making budgeting and forecasting decisions.

The 3 Way Model can also be used to stress test strategies, assess investment returns, plan capital expenditure and measure financial performance. It is a powerful tool that can help decision-makers increase their understanding of their business, enabling them to make better strategic choices.

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