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
- Document all assumptions on a dedicated page
- Color code: blue = input, black = formula, green = linked from another sheet
- 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