An Overview of the Components of a 3 Way Financial Model

Introduction

A 3 way financial model is a tool used by finance professionals to forecast the expected financial performance of a business. This model consists of three separate components - an income statement, a balance sheet, and a cash flow statement. It allows users to evaluate the current health of a business by looking into changes in revenues and expenses over a given period of time.

In this blog post, we’ll take a look at the various components of a 3 way financial model, and how they work together to provide a complete assessment of the financial performance of a business.

Key Takeaways

• 3 way financial models are a tool used by finance professionals to forecast the expected financial performance of a business.
• The model consists of three separate components: an income statement, a balance sheet, and a cash flow statement.
• It allows users to evaluate the current health of a business by looking into changes in revenues and expenses over a given period of time.

The Income Statement

The income statement is one of the most important parts of a 3 way financial model and is a key component for understanding profit. It is also central to assessing the financial health of a business, or predicting the likelihood of growth.

Definition

Income statement is an accounting statement that tracks all revenues and expenses over a period of time, typically a fiscal quarter or year. It includes revenues and expenses related to operating activities, investing activities and financing activities. The total profit or loss is indicated at the end of the statement.

Overview of Key Figures

The income statement consists of key figures that summarize the results of the company’s operations. This includes total revenue, total expenses, cost of goods sold (COGS), operating income, net income and earnings per share (EPS). Together, these figures give an indication of how profitable the business is and how productive it has been in generating profits for shareholders.

• Total revenue: This is the sum of all revenue generated from selling goods and services for the period. It is the "top line" figure that shows the overall economic health of the company.
• Total expenses: This is the sum of all operating expenses incurred from producing and selling goods and services. This includes salaries, rent and other administrative costs.
• Cost of goods sold (COGS): This is the cost associated with producing and selling goods and services, such as labor costs and materials. It must be subtracted from total revenue to arrive at the gross profit.
• Operating income: This is the profit (or loss) for the period, before non-operating items such as interest and taxes. It is calculated by subtracting total expenses from total revenue.
• Net income: This is the "bottom line" profit (or loss) after all expenses, interest and taxes are accounted for. It is calculated by subtracting all non-operating expenses from operating income.
• Earnings per share (EPS): This is the amount of earnings per share of common stock outstanding during the period. It is calculated by dividing net income by the number of outstanding shares.

The Balance Sheet

A balance sheet is one of three financial statements used to assess a business's financial position and health—the others being an income statement and a cash flow statement. A balance sheet is generated at a single point in time, typically at the close of an accounting period, and reports a company's assets, liabilities, and shareholder equity at that specific point in time.

The balance sheet summarizes the assets and liabilities of the business and serves to provide the business’s net worth at any given point in time. Generally, the assets must offset the liabilities, thus the final number is the net worth of the company.

Definition

The Balance Sheet is often referred to as a snapshot of a company’s net worth or its financial health at a specific point in time. It is the statement prepared to show the overall financial situation of a company at the end of a specified period of time. It is comprised of two sides, the debit side (assets) and credit side (liabilities and shareholders’ equity). For an entity to be financially healthy, the total asset value must equal that of total liabilities and shareholder’s equity.

Overview of key figures

The Balance Sheet includes several different financial figures that must be taken into account. The following are some of the major items:

• Assets: Any resource that is expected to produce economic benefits in the future. Examples include cash, inventory, accounts receivable, equipment, real estate, etc.
• Liabilities: Financial obligations of a company to repay debts to outside parties. Examples include accounts payable, long-term debt, taxes, etc.
• Shareholders’ Equity: The value of funds that have been invested into the company by the owners or shareholders of the business.
• Total Assets: The sum of all assets
• Total Liabilities: The sum of all liabilities and shareholder equity

The Cash Flow Statement

The cash flow statement provides a comprehensive view of where cash is coming from, the sources of that cash, and what it is being used for. It gives a clear picture of the growth in liquidity over a specified timeframe. The cash flow statement typically covers both inflows and outflows of cash between specific parties in the form of operations, investments, and financing. It is also useful for tax, legal, and compliance purposes.

Definition

A cash flow statement is a financial statement that summarises the cash flows of a company between two or more accounting periods or dates. Cash flows are classified within this statement as operating, investing, and financing activities. The primary purpose of a cash flow statement is to show how the company’s net cash has changed over the period of time studied.

Overview of Key Figures

The following key figures will appear in the cash flow statement:

• Net cash provided (used) by operating activities.
• Net cash provided (used) by investing activities.
• Net cash provided (used) by financing activities.
• Net change in cash and cash equivalents.
• Beginning Cash and Cash Equivalents.
• Ending Cash and Cash Equivalents.

Financial Modeling Leverage Ratios

Financial leverage ratios are used to gauge a company's ability to pay off its long-term debt. These ratios are typically based on a combination of a company's assets, liabilities, and equity.

Definition

Financial leverage ratios are used to measure the company’s ability to meet its long term debt obligations. The leverage ratios measure the relationship between the debt and equity that the company has on its balance sheet.

Overview of Key Figures

The three most common financial leverage ratios are the debt-to-equity (D/E) ratio, the debt-to-assets (D/A) ratio, and the equity-to-assets (E/A) ratio.

• Debt-to-Equity (D/E) Ratio - This ratio measures a company's financial leverage and is calculated as the total debt divided by total equity. This ratio shows the degree of financial risk that a company is taking in financing its operations.
• Debt-to-Assets (D/A) Ratio - This ratio measures the proportion of a company's assets that are financed through debt and is calculated by dividing total debt by total assets. This ratio indicates the company's degree of financial leverage and is used to assess its financial risk.
• Equity-to-Assets (E/A) Ratio - This ratio measures the proportion of a company's assets that are financed through equity and is calculated by dividing total equity by total assets. This ratio indicates the company's dependence on equity financing and is also used to assess its financial risk.

Discounted Cash Flow Analysis

Discounted Cash Flow Analysis (DCF) is an approach used to analyze investments and project returns. This method calculates the present value of future cash flows, discounted to the present moment. Employing this approach helps in determining the investment’s return rate, which guides investors in making informed decisions as to whether or not it’s a wise investment.

a. Definition

DCF analysis is a method of valuing a project, company, or asset utilizing the concepts of the time value of money. It can be used to give an estimate of a particular project's or firm‘s value by discounting the expected future cash flows. This analysis involves the creation of a model, which can be tailored to suit various situation, in order to project the expected cash flows.

b. Overview of key figures

Working out the present value of a set of cash flows involves three key figures: the discount rate, the initial outlay, and the series of expected cash flows. The discount rate is the rate of return which must be exceeded in order for an investment decision to be profitable and the initial outlay is the initial investment of the current period. The series of expected cash flows is the forecast of future cash inflows and outflows of each period thereafter.

• Discount rate – the rate of return which must be exceeded in order for an investment decision to be profitable
• Initial outlay – the initial investment of the current period
• Expected cash flows - individual forecast of future cash inflows and outflows for each period

Conclusion

A 3 way financial model provides a comprehensive overview of a company's financials. By breaking down the model into elements such as income statement, balance sheet, cash flow statement and assumptions, financial analysts can build a comprehensive picture of the company’s financials now and into the future. With a framework in place, assumptions can be adjusted to analyze the effects of business strategies, financial decisions and market conditions. Ultimately, a 3 way financial model aids financial decision makers in understanding their financials, driving better business decisions and growing the company.