Three-statement model
Question
Do the income statement, balance sheet, and cash flow statement tie — and what does the integrated picture say about the business?
Inputs
| Input | Source |
|---|---|
| Historical income statements (3–5 years) | Filings, audited statements |
| Historical balance sheets (3–5 years) | Same |
| Historical cash flow statements (3–5 years) | Same |
| Operating assumptions (growth, margins, working capital) | Management guidance, historical patterns, peer benchmarks |
| Capital expenditure and depreciation policy | Filings, asset register, peer benchmarks |
| Financing assumptions (interest rate, debt amortization, dividend policy) | Debt schedule, dividend history |
A three-statement model is the engine. Every valuation method bolts on top of it.
Procedure
- Lay out the income statement. Revenue down to net income. Each line either grows off the prior year (revenue, expenses tied to revenue) or follows a stated policy (depreciation, interest, tax).
- Lay out the balance sheet. Assets, liabilities, equity. The accounting identity must hold every year — assets equal liabilities plus equity. If it does not, the model is broken.
- Lay out the cash flow statement. Three sections: operating, investing, financing. Operating cash flow starts from net income, adds back non-cash items, adjusts for changes in working capital. Investing reflects capital expenditure and acquisitions. Financing reflects debt drawn or repaid, equity issued or bought back, dividends.
- Tie the three. Cash on the balance sheet equals prior-year cash plus the change in cash from the cash flow statement. Retained earnings on the balance sheet equals prior-year retained earnings plus net income minus dividends. Property, plant, and equipment equals prior-year balance plus capital expenditure minus depreciation. Every linkage closes the loop.
- Build the working capital schedule. Accounts receivable, inventory, accounts payable — each as a function of revenue or cost of goods sold. The change feeds the cash flow statement.
- Build the debt schedule. Beginning balance, draws, repayments, ending balance per tranche. Interest expense applies to the average balance. Interest feeds the income statement; the principal change feeds financing cash flow.
- Build the equity schedule. Beginning equity, plus net income, minus dividends, plus or minus share issuance or buybacks. Ending equity ties to the balance sheet.
- Verify the ties. Net income from the income statement appears in the cash flow statement and changes retained earnings. Depreciation adds back in the cash flow statement and reduces the asset balance. Interest expense matches the average debt balance times the rate. The balance sheet balances every year.
- Stress the model. Vary one driver at a time — revenue growth, gross margin, capital expenditure intensity, working capital days. Confirm the three statements still tie under each shock.
Gates
- The balance sheet does not balance in any projected year — the model is broken
- Cash on the balance sheet diverges from cash on the cash flow statement
- Depreciation on the income statement does not match the change in accumulated depreciation
- Retained earnings change does not equal net income minus dividends
- Working capital changes do not flow correctly into operating cash flow
- An input has no source comment
Output
An integrated three-statement model that closes every year. The model serves as input to every other valuation method — discounted cash flow, leveraged buyout, comparable analysis. Numbers stage for review by a qualified professional.
Common Mistakes
- Modeling depreciation independently on the income statement and the cash flow statement (they must reconcile)
- Forgetting interest is calculated on the average balance, not the ending balance
- Failing to update the share count when buybacks or issuances are modeled
- Treating non-cash items as cash items in operating cash flow
- Plugging the balance sheet to balance instead of finding the actual error
Adjacent Methods
- Discounted cash flow — runs on top of the three-statement model
- Leveraged buyout model — adds a debt schedule and exit
- Earnings analysis — the historical view that calibrates assumptions
Questions
Does the balance sheet balance in every projected year?
- Does cash on the balance sheet tie to cash on the cash flow statement?
- Have I stressed the model with one-driver-at-a-time shocks?