Introduction
A 3 way financial model is an analytical tool used by finance teams to make informed decisions regarding a company's cash flows, balance sheet, and income statement. It provides stakeholders with an understanding of past, present, and future financial states of the business. Developing a 3 way financial model can give a business insight into its financial trends and help to build strategies for future investments and performance.
The benefits of developing a 3 way financial model include:
- Provides an understanding of past, current, and future financial states of the business.
- Identifies issues with financial performance and suggests strategies for improvement.
- Informs investments decisions and the development of business strategies.
- Enables accurate forecasting of cash flow and operating performance.
Key Takeaways
- A 3-way financial model provides an understanding of past, present, and future financial states of the business.
- Developing a 3-way model can reveal issues with financial performance and provide strategies for improvement.
- Having an accurate and informative model can inform investment decisions and the development of business strategies.
- Accurate forecasting of cash flow and operating performance is made possible through a 3-way model.
Establish Formula for Total Cost
To develop an effective 3 way financial model, it is important to establish an accurate formula for total cost. This can be done by itemizing all processes and associated costs into variable and fixed components.
Itemize Process and Cost into Variable and Fixed
The first step is to break down each process and cost into either variable or fixed components. Variable costs are those which can change depending on the level of production, such as the cost of raw materials or labour. Fixed costs are those which remain the same regardless of production levels, such as rent, insurance and depreciation.
Determine Fixed Costs
Once the process and costs have been itemized, it is then necessary to calculate the total for each type of cost. Fixed costs should be determined by calculating the total expected expenditure over the life of the project. It is important to take into consideration any changes in market conditions which will effect the pricing of items.
Determine Variable Costs
Variable costs should be calculated based on the projected levels of production. This should be done by estimating the cost of each unit of production and then multiplying that by the number of units required. It is important to monitor changes in prices and demand as this will impact the total cost of production.
Once the total cost of each type of cost has been determined, it is possible to establish an accurate formula for total cost. This can be done by summing the fixed and variable costs and then subtracting any government subsidies or other forms of financial aid to arrive at the total cost.
Create Income Forecast
The goal of this step is to incorporate the details of the financial model into a three-way financial model that contains both the income and expenditure forecasts. Establishing a baseline income forecast will provide the foundation for creating a realistic three-way financial model. Furthermore, the baseline income forecast will be used to generate and adjust assumptions for future income estimates.
Establish Baseline for Forecast
The first step to creating a three-way financial model is to establish a baseline for the income forecast. This baseline should include both current and future income estimates. When setting up the income forecast, it is important to consider both short-term and long-term goals. As such, the baseline income forecast should include all estimated income for the upcoming period, including any anticipated changes in current income. The baseline should also consider potential fluctuations in income that could occur due to changes in the economic environment.
Set Assumptions
Once the baseline income forecast is established, the next step is to set assumptions for the income forecast. The assumptions should include additional items that could affect the income estimates, such as expected inflation, changes in market conditions, etc. It is also important to consider how uncertain these assumptions are and how they could differ from the actual results. Once the assumptions are determined, these estimates should be incorporated into the baseline income forecast.
Adjust Estimates
The last step is to adjust the income forecast based on the assumptions outlined in the previous steps. This may include making adjustments for changes in the economic environment, such as adjusting for inflation or changes in market conditions. It is also important to consider how these changes could affect the other income and expenditure forecasts in the three-way financial model. Once all adjustments have been made, the three-way financial model can be finalized.
Establish Baseline for Balance Sheet
Developing a 3 way financial model begins with establishing a baseline for the balance sheet. This entails calculating appropriate assets and liabilities and then using these values to equate the sum of the liabilities and equity.
Establish Formula for Assets and Liabilities
In order to accurately represent the financial position of the institution, a formula needs to be established for each asset and liability. This will ensure that all values are calculated precisely and accurately. The formula should include the following components:
- Current market value
- Historical price
- Exchange rate
- Interest rate
Use Assets to Equal Sum of Liabilities and Equity
Once a formula has been established, the assets and liabilities need to be calculated using the appropriate formula. These calculated values can then be used to ensure that the sum of the liabilities and equity equal the current asset value. This must be done to ensure accuracy and to ensure that the model is reflective of the institution's current financial position.
Creating Assumptions for Future Cash Needs
Creating a three-way financial model requires forecasts for future cash needs. This includes cash needed for both operational and capital expenditure needs, as well as financial requirements. The following explain how to create assumptions for the future cash needs.
Estimate Cash Need for Operations
Cash needs for operations include all the current financial requirements of an organization such as payroll expenses, costs of materials, and rent, as well as any other expenses related to operating the business. It is important to make assumptions about how much cash the organization will need to cover these expenses in the future. In order to estimate the cash need for operations in the future, one should consider the historical costs of running the business and the expected changes in the future.
Estimate Capital Expenditure Needs
Capital expenditure needs should also be considered when estimating future cash needs. Capital expenditure refers to money spent to purchase, maintain, or improve tangible assets such as real estate or machinery. When estimating the amount of capital expenditure needed in the future, one should consider both the current and expected future needs of the organization. Additionally, one should also consider any potential new investments that may be necessary in the future.
Estimate Financial Requirements
Financial requirements refer to the money needed to fund operations and capital expenditure. This includes both short-term operational costs and longer-term capital expenses. When creating assumptions for future financial requirements, one should consider the organization's current financial position, as well as how its financials are expected to change in the future. Additionally, one should also think about how the organization will fund its financial requirements, such as through bank loans, venture capital, or other sources.
Construct Statement of Cash Flow
Constructing a statement of cash flow requires careful analysis of the company’s income and expenditure for a 3 way financial model. Cash flow statements illustrate the timing of cash receipts and payments when compared to expected future commitments and liabilities.
Deduct Capital Expenditure and Operating Cash Flows from Total Cash
The statement of cash flow begins with the total available cash from all sources including borrowings and investments. This is then reduced by any capital expenditure incurred and operating cash flow spent during the period of the 3 way financial model.
Account for Change in Cash
An account should also be kept of any change in cash positions. There are many sources of cash changes, such as payments on loans, dividends paid, bank interest earned, investor withdrawals and payments to suppliers. All changes must be factored into the statement of cash flow in order to generate an overall cash position at the end of the period.
It is important to note that a statement of cash flow shows the cash position of a company over a certain time period as dictated by the 3 way financial model, not the profit-making or loss-making activities during that period.
Conclusion
Developing a 3 way financial model can be complex and overwhelming for even the most experienced professionals. However, with a thorough understanding of the steps, the process can be a relatively easy one. The first step to developing a 3 way financial model is to determine the scope and purpose of the model. From there, one can move on to obtain the necessary inputs for the model, construct their model in a software such as Excel, and then input the data, determine the assumptions and constraints, and finally develop the outputs. After the model is complete and testing is complete, it is important to review and analyze the final results, and then utilize the model to create scenarios to determine different results.
By following these steps, one can create an effective and organized 3 way financial model that conveys their desired information in a concise and approachable way. With this model now complete, it is possible to gain a deeper understanding of the financial processes by forming various scenarios and analyzing the different outcomes. This understanding can help financial experts make more informed decisions going forward.