Introduction
A 3-Way Financial Model is a comprehensive budgeting and forecasting tool used in business to analyze the financial performance of a venture or project. It is the combination of three statements: a Cash Flow Statement, Balance Sheet and Income Statement, and is a useful tool for making projections and assessing trends.
Benefits of a 3-Way Financial Model
- Enables better financial decision making – users can make informed decisions using the information pulled from the three statements.
- Gives a longer-range projection of an enterprise’s financial position – provides forecasted figures for each period of time, enabling users to predict their future results.
- Contains all the necessary financial information – the 3-Way Financial Model includes all necessary data elements and is easy to interpret.
- Provides a clear picture of the company’s performance – makes it easy to assess how a business is doing financially.
Key Takeaways:
- Enables better financial decision making
- Gives a longer-range projection of an enterprise’s financial position
- Provides a clear picture of the company’s performance
- Contains all the necessary financial information
Balance Sheet Prep
To ensure that three way financial models are comprehensive and accurate, it is important to have reliable and comprehensive data for the balance sheet. This requires inputting historical balance sheet data and then estimating future balance sheet items.
Inputting Historical Balance Sheet Information
The most important step in the balance sheet prep process is to ensure that past balance sheet information is accurately inputted into the model. This will ensure that the cash flow statements are accurate and that future balance sheet projections are based on a reliable starting point. This can be done by manually entering data into the spreadsheets, or by using an external file to create a linked table.
Estimating Future Balance Sheet Items
Once historical balance sheet information is in the model, the next step is to estimate future balance sheet items. This process requires estimating the amount and timing of future cash flows, projecting accounts payable and receivable, inventory, stock-based compensation and other items. Approaches such as bottom-up and top-down analysis, discounted cash flow techniques and macroeconomic drivers can be used to make appropriate and realistic estimates.
Once the balance sheet has been prepared, the rest of the three way financial model can be completed. This will involve completing the income statement and cash flow statements, which rely on the data from the balance sheet to be accurate.
Income Statement Prep
When constructing a 3-way financial model an income statement, or profit and loss statement, is the second component of the projected financials side. Once the modeled assumptions of the balance sheet and cash flow statements have been completed, the income statement then ties in all the assumptions across the model.
Typical Structure
The structure of the income statement typically has revenues at the top and expenses at the bottom, with net profit from operations (NOPAT) coming in the middle. It is the most consolidated view of the model since it summarizes the operations side of the business. All expenses are broken down into their respective buckets, such as cost of goods sold, depreciation, tax expenses, and net selling, general and administrative expenses.
Setting up Departments
Since revenues are represented as the top line item on the income statement, the type of revenue and department that it relates to is significant. Are there multiple revenue streams flowing into the company or just one; will there be a shift of service offerings over time; and are sales coming from physical or digital products? These are all questions that the financial modeler must clearly define when setting up the departments.
Estimating Future Financials
The most important element of building out the income statement is to accurately forecast the projected financials of the business. This requires adjusting the assumptions used for the balance sheet, such as changes in inventory levels, receivables aging, depreciation, and amortization. The modeler should focus on capturing the assumptions of the business across each department in order to estimate the NOPAT of the business.
Cash Flow Statement Preparation
A 3-way financial model should include a cash flow statement in order to assess the liquidity and finance of the business, analyze how cash is used, identify cash flow risks and variances, and to make decisions on how to maximize cash flow. The cash flow statement is divided into three sources of cash: operations, investments, and financing.
3 Sources of Cash in a Business
- Operations: Cash generated from operations, such as sales, payments received from customers and other income-generating activities.
- Investments: Cash generated or lost from investing activities, such as the purchase or sale of assets and investments.
- Financing: Cash generated from obtaining financing, such as loans, debt financing, and equity investments from stockholders.
Estimating the Level of Cash Inflow and Outflow
In order to estimate the cash inflow and outflow of each of the three sources of cash, the modeler should gather historical financial statements and review past trends from past periods. The modeler should gather and analyze information on potential new sales and investments in upcoming periods, and then make an educated estimate of operations, investments, and financing needs in the periods covered by the model.
The cash flow statement is then completed by subtracting the cash outflows from cash inflows, and subtracting any in-flows or out-flows due to changes in current period liabilities and deferred income. Finally, the change in cash flow is added or subtracted from the beginning balance to determine the ending balance.
Benefits of Modelling
A 3-way financial model is one of the most effective ways to assess the strengths and weaknesses of a business. This type of modelling, which takes into account revenue, expenses, and taxes all at once, can inform key decisions and provide an invaluable wealth of insight. When done correctly, a 3 way model offers a number of benefits.
Versatility
One of the primary benefits of 3-way modelling is its versatility. This type of modelling can be used to assess the financial health of a business on an ongoing basis, as well as to evaluate potential strategic decisions. For example, a 3-way model can be used to understand the potential impact of a new product on revenue, as well as the associated cost of operating and selling the product, and the tax implications.
Sensitivity Analysis
In addition, 3-way modelling can be used for sensitivity analysis, or the examination of how one parameter might change in the future, and the resulting effects. This type of analysis allows the user to see how changes in variables like taxes, costs, or revenues might affect the overall financial health of the business, enabling strategic decisions to be made with confidence.
Bottom Line Evaluations
Finally, 3-way modelling is invaluable for making informed evaluations of the bottom line of any business. This type of modelling provides an accurate picture of the financial situation at the present, including potential opportunities and risks. By allowing users to accurately model different outcomes, 3-way modelling enables decision-makers to make the best decision to improve their bottom line.
Challenges of Modelling
Constructing a 3 way financial model to represent a company’s performance can prove to be a difficult endeavour. It is built with the intent to define the multi-year financial performance that best reflects the company’s present state and future prospects. Building a reliable 3 way financial model requires resources and intelligent work.
Statistical Reliability of Data Sources
In building a financial model, one of the most difficult tasks become collecting and compiling reliable data such as industry standards and observations, historical trends and results, current trends, and various other financial data. The reliability of the data used in the 3 way model highly depends on the source, thus an understanding of the origin of the data is a vital thinking process of the financial modeler. Without an understanding of the origin of data, the interpretation of the results might be off and the model could turn out to be biased.
Financial Forecasting
To accurately reflect a company’s performance, appropriate financial forecasts are essential. However, providing accurate forecasts involves making assumptions about future conditions, which can be complex. Many variables must be accounted for, such as customer trends, economic trends, assets and liabilities, market trends and analysts’ forecasts. Regardless of the type of 3 way financial model, accurately predicting the future performance of a company is a difficult task, as the future is unpredictable.
To truly reflect the financial health of a company, one has to not only integrate the perspectives from external sources, such as analyst reports and customer opinions, but also combine them into a comprehensive view. Having a comprehensive view of the overall financial picture of a company is something that allows for more accurate modelling. By taking into consideration the external perspectives, a 3 way financial model might be more accurately framed in terms of customer behaviour and the economy.
Conclusion
An effective 3-Way Financial Model is an essential tool for evaluating the overall financial performance of a business. With the right building blocks and thoughtful application, a 3-Way Financial Model provides invaluable insight into creating strategic plans, forecasting cash flow and predicting future performance.
This article provided an overview of the essential elements required for a 3-Way Financial Model. A structured approach, utilizing market research, industry-specific data, corporate strategy and financial forecasts are important components used to successfully create a 3-Way Financial Model.
The potential benefits of such a model are substantial. From improved decision making to better cash management and increased value for shareholders, this model provides organizations with the information needed to more effectively manage resources and anticipate future performance.
By combining the three financial statements, preparing forecasts and tailoring the model to the organization’s needs, a 3-Way Financial Model serves as an effective tool to accurately represent the current state of an organization’s financial wellbeing and future potential.