Lesson 75 - Intermediate Accounting Course 

75. Three-Statement Financial Model: Linking Income, Balance Sheet, and Cash Flow

A Three-Statement Financial Model integrates the Income Statement, Balance Sheet, and Cash Flow Statement into one dynamic system. This model helps businesses forecast financial performance, analyze key metrics, and make informed decisions.

1️⃣ What is a Three-Statement Model?

The three financial statements provide different perspectives on a company’s financial health:

• Income Statement → Shows profitability over a period 📈
  
  

• Balance Sheet → Provides a snapshot of financial position 🏦
  
  

• Cash Flow Statement → Tracks cash inflows and outflows 💰
  
  

Why Link Them?
Each statement affects the others. For example:
✔️ Net income from the income statement affects retained earnings in the balance sheet.
✔️ Depreciation appears as an expense in the income statement but is a non-cash adjustment in the cash flow statement.
✔️ Changes in working capital (inventory, accounts receivable, etc.) impact cash flow.

2️⃣ Steps to Build a Three-Statement Model in Excel

Let’s create a basic linked model for a company.

Step 1: Set Up the Income Statement

Key Formulas:

• Revenue: Based on price × quantity
  
  

• Gross Profit: Revenue - Cost of Goods Sold (COGS)
  
  

• Operating Profit (EBIT): Gross Profit - Operating Expenses
  
  

• Net Income: EBIT - Interest - Taxes
  
  

💡 Example in Excel:

Net Income = EBIT - Interest - Taxes

Net income flows into the balance sheet as retained earnings and the cash flow statement as starting cash flow from operations.

Step 2: Build the Balance Sheet

Key Sections:
✔️ Assets = Cash, Inventory, Accounts Receivable, Fixed Assets
✔️ Liabilities = Debt, Accounts Payable
✔️ Equity = Common Stock, Retained Earnings

📌 Formula for Retained Earnings:

New Retained Earnings = Old Retained Earnings + Net Income - Dividends

Linking Rule:

✔️ Net Income (Income Statement) increases retained earnings

✔️ Capital expenditures increase fixed assets

✔️ Debt repayments reduce liabilities and cash 

Step 3: Set Up the Cash Flow Statement

Cash flow consists of:
✔️ Operating Activities: Net income + Depreciation + Working Capital Changes
✔️ Investing Activities: Capital expenditures, investments
✔️ Financing Activities: Loans, stock issuance, dividend payments

📌 Formula for Ending Cash Balance:

Ending Cash = Beginning Cash + Cash from Operations + Cash from Investing + Cash from Financing

Linking Rule:

✔️ Net Income (Income Statement) → Starts Cash Flow from Operations

✔️ Capital Expenditures (Balance Sheet) → Cash Flow from Investing

✔️ Debt Issuance/Repayment (Balance Sheet) → Cash Flow from Financing 

3️⃣ Linking All Statements Together 

Final Formula Flow:

1️⃣ Net Income → Retained Earnings (Balance Sheet)
2️⃣ Depreciation → Adds back in Cash Flow (non-cash expense)
3️⃣ Debt Issued/Repaid → Adjusts both Balance Sheet and Cash Flow
4️⃣ Capital Expenditures → Affects Assets and Cash Flow

4️⃣ Why Use a Three-Statement Model?

✅ Accurate forecasting: Helps predict future profitability and cash needs
✅ Scenario analysis: Adjust assumptions (e.g., price changes, cost inflation) to see financial impact
✅ Investment decisions: Evaluate whether a company has enough cash flow to support growth