Three-Statement Model

The three main financial statements are connected. Net income from the income statement increases retained earnings on the balance sheet and is the starting point for the cash flow statement. The cash flow statement explains how the cash balance on the balance sheet changes from one period to the next. Changes in balance sheet items, such as receivables and inventory, affect cash flow.

A three-statement model captures all these links. For example, if forecast sales rise by 10%, the model automatically increases revenue and costs on the income statement, raises receivables and inventory on the balance sheet and reduces operating cash flow to reflect the cash tied up in that extra working capital.

A key test of a correctly built model is that the balance sheet balances in every forecast period, with total assets equal to liabilities plus equity.

Three-statement models are the foundation of many other analyses, such as company valuations, loan planning and acquisition analysis.

Note: An integrated financial model means the same as a three-statement model. Both terms describe forecasts in which the three statements are fully linked.