Three-Statement Financial Modeling

Framework

IRON LAW: The Three Statements Must Balance

Assets = Liabilities + Equity (Balance Sheet identity)
Net Income flows from IS to BS (retained earnings)
Cash flow bridges IS and BS through working capital and capex

If your model doesn't balance, there's an error. Check the cash line on
the BS against the ending cash on the CF statement. They MUST match.

Model Architecture

[Assumptions Page] → drives everything
    ↓
[Income Statement] → Revenue, costs, taxes → Net Income
    ↓
[Balance Sheet] → Assets, liabilities, equity → must balance
    ↓
[Cash Flow Statement] → Start cash + Operating + Investing + Financing = End cash
    ↓
[Outputs: DCF, Returns, Scenarios]

Revenue Forecasting Methods

Method	How	Best For
Top-down	Market size × market share × price	New markets, macro-driven
Bottom-up	Units × price, or customers × ARPU	Established products, SaaS
Run-rate	Current monthly × 12, adjusted for growth	Near-term projections
Cohort-based	New cohort revenue + existing cohort retention	Subscription businesses

Key Assumptions to Document

Category	Assumptions
Revenue	Growth rate, pricing, volume, churn (if subscription)
COGS	Gross margin trajectory, input cost inflation
OpEx	Headcount plan, salary inflation, marketing as % of revenue
Working Capital	DSO (days sales outstanding), DPO (days payable), DIO (days inventory)
CapEx	Capital expenditure as % of revenue or specific projects
Tax	Effective tax rate, tax loss carryforwards
Financing	Debt schedule, interest rates, equity raises

Building Steps

Phase 1: Assumptions

1. Document all assumptions on a dedicated page
2. Color code: blue = input, black = formula, green = linked from another sheet
3. Each assumption must have a source or rationale

Phase 2: Income Statement 4. Build revenue line from assumptions 5. COGS and gross profit 6. Operating expenses by category 7. EBITDA, depreciation, EBIT 8. Interest, taxes, net income

Phase 3: Balance Sheet 9. Working capital items from IS drivers (DSO × Revenue/365, etc.) 10. Fixed assets: prior period + capex - depreciation 11. Debt schedule: prior period + new borrowing - repayment 12. Equity: prior period + net income - dividends + equity raises 13. CHECK: Assets = Liabilities + Equity

Phase 4: Cash Flow 14. Start with net income 15. Add back non-cash items (depreciation, amortization) 16. Working capital changes (from BS period-over-period) 17. CapEx (investing) 18. Debt and equity changes (financing) 19. CHECK: Ending cash = BS cash line

Phase 5: Scenarios 20. Base case (most likely assumptions) 21. Bull case (optimistic — higher growth, better margins) 22. Bear case (pessimistic — lower growth, margin pressure)

Output Format

# Financial Model: {Company} — {Projection Period}

## Key Assumptions
| Assumption | Y1 | Y2 | Y3 | Y4 | Y5 | Source |
|-----------|-----|-----|-----|-----|-----|--------|
| Revenue growth | {%} | {%} | {%} | {%} | {%} | {basis} |
| Gross margin | {%} | ... | ... | ... | ... | ... |
| OpEx growth | {%} | ... | ... | ... | ... | ... |

## Projected Income Statement
| | Y1 | Y2 | Y3 | Y4 | Y5 |
|---|-----|-----|-----|-----|-----|
| Revenue | ${X} | ... | ... | ... | ... |
| Gross Profit | ${X} | ... | ... | ... | ... |
| EBITDA | ${X} | ... | ... | ... | ... |
| Net Income | ${X} | ... | ... | ... | ... |

## Scenario Comparison
| Metric (Y5) | Bear | Base | Bull |
|-------------|------|------|------|
| Revenue | ${X} | ${X} | ${X} |
| Net Income | ${X} | ${X} | ${X} |
| FCF | ${X} | ${X} | ${X} |

## Balance Check
- BS balances: ✓/✗
- CF ending cash = BS cash: ✓/✗

Gotchas

• Revenue is the most sensitive assumption: A 2% difference in growth rate compounds enormously over 5 years. Always present a range, not a point estimate.
• Working capital is often forgotten: Fast-growing companies consume cash in working capital (building inventory, extending credit). A profitable company can run out of cash if working capital isn't modeled.
• Circular references with interest: Interest expense depends on debt balance, which depends on cash (which may require more debt). Break the circularity with an iterative calculation or prior-period debt balance.
• Granularity should match certainty: Model Year 1 monthly, Year 2 quarterly, Years 3-5 annually. Detailed monthly projections for Year 5 are false precision.
• Assumptions page is the most important page: Nobody should need to dig into formulas to understand what drives your model. All assumptions visible, documented, and changeable in one place.

References

• For DCF valuation built on the three-statement model, see the biz-dcf skill
• For spreadsheet best practices, see references/modeling-best-practices.md