The Cast of Characters: Understanding Each Statement

• Income Statement (IS): The Income Statement, or Profit and Loss Statement, is the storyteller of our trio, recounting the tale of a company’s revenues, expenses, and profits over a period. It begins with sales, subtracts out costs to reveal gross profit, deducts operational expenses to display operating profit, and after accounting for taxes and interest, presents the net income—the company’s earnings.
• Balance Sheet (BS): The Balance Sheet is the keeper of equilibrium, a snapshot in time showing what a company owns (assets) and owes (liabilities), with the difference being shareholders’ equity. It is governed by the fundamental equation: Assets = Liabilities + Equity.
• Cash Flow Statement (CFS): The Cash Flow Statement is the tracker of liquidity, detailing the inflows and outflows of cash through operating activities, investing activities, and financing activities. It reconciles the beginning and ending cash balances, revealing how a company generates and uses its cash.

The Dance Begins: Linking the Statements

The true magic of three-statement modeling lies in the intricate ballet of numbers, where each statement’s elements influence and are influenced by the others. Here’s how the dance unfolds:

• From IS to CFS: The net income from the bottom of the Income Statement serves as the opening act of the Cash Flow Statement, under operating activities. Non-cash expenses from the IS, like depreciation and amortization, are added back to net income, and changes in working capital (found in the Balance Sheet but reflected in cash flows) are adjusted to translate the accrual accounting of the IS into the cash reality of the CFS.
• From IS to BS: The net income, after dividends are subtracted, contributes to retained earnings, a component of shareholders’ equity on the Balance Sheet. Meanwhile, expenses such as depreciation affect both the IS (as an expense) and the BS (reducing the value of assets).
• From CFS to BS: The closing cash balance in the Cash Flow Statement becomes the cash line item on the Balance Sheet. The activities reflected in the CFS—whether from operations, investments, or financing—also influence other parts of the Balance Sheet, such as investments, debt, and equity accounts.

Crafting the Model: The Alchemy of Integration

Creating a three-statement model requires not just an understanding of each statement’s individual components but also an appreciation for the alchemy of their integration. Here are the steps to building your model:

1. Start with the Income Statement: Forecast revenues, cost of goods sold (COGS), and other expenses based on historical data, industry trends, and company guidance to derive the net income.
2. Build the Balance Sheet: Use the ending balances from the previous period as the starting point, and project changes based on the operations reflected in the Income Statement and Cash Flow Statement. Remember, every action in the IS and CFS has a reaction in the BS.
3. Complete the Cash Flow Statement: Begin with net income from the IS, adjust for non-cash items, and reflect changes in working capital. Then, incorporate cash from investing and financing activities to find the ending cash balance, which must match the cash shown on the BS.
4. Iterate and Refine: Three-statement modeling is an iterative process. As you input assumptions and project future numbers, constantly check that the three statements remain in harmony, adjusting as necessary to ensure accuracy and consistency.

The Symphony of Numbers

Mastering three-statement modeling is like conducting a symphony, where each section plays its part in harmony with the others. It’s a skill that demands both a meticulous eye for detail and an ability to see the bigger picture—how each number, each assumption, resonates through the entire model.

For the aspiring financial gladiator, proficiency in three-statement modeling is not just a tool; it’s a weapon—one that cuts through the noise and complexity to reveal the true financial story of a company. So, arm yourself with knowledge, practice relentlessly, and step forth into the arena of financial analysis with confidence. The art of three-statement modeling awaits, ready to unveil the narratives hidden within the numbers.