Demystifying the Three-Statement Financial Model: A Guide for Beginners

For instance, imagine your uncle has invested $100,000 in a tequila company and claims it will be worth $1 million in 5 years. A robust financial model can help you assess the likelihood of this claim by projecting the company’s future cash flows. The goal isn’t to be precisely correct but to avoid being drastically wrong.

Now, you might wonder why we need three statements instead of just one. The answer lies in the limitations of each individual statement. The income statement, for example, focuses solely on profit and loss. It doesn’t account for transactions like changes in accounts receivable and payable, which can significantly impact a company’s cash flow.

On the other hand, the three-statement model captures all the important facets of a business’s operations. It projects forecasted balances of working capital elements such as accounts receivables, inventory, and prepaid expenses. This is crucial because a company with high working capital demands can seem profitable on the surface but actually be in the red once the cash flows are laid bare.

The three-statement model also benefits business leaders by providing better insight into their companies. For example, a CEO might be surprised to find that despite high EBITDA margins, the valuation of her company is lower than expected due to significant cash tied up in working capital. This insight can help her prepare for future cash outflows and make more informed decisions.

Investors and buyers also benefit from three-statement models. These models allow them to look past profitability and assess the cash yield of a potential investment. Even when a company is profitable and growing, it may lose cash because of high working capital requirements.

In conclusion, the three-statement financial model is a powerful tool for understanding a company’s financial health. It provides a comprehensive view of a company’s operations, helping stakeholders make informed decisions. While it may require more time and expertise to build, the insights it provides are well worth the effort.

Remember, in the world of finance, knowledge is power. And the three-statement financial model is one of the most powerful tools at our disposal.