Build a Three-Statement Model: Step-by-Step Guide for First-Year Analysts

Three-Statement Model: Build, Link, and Audit Right

A three-statement model links the income statement, balance sheet, and cash flow statement so every forecasted number connects and reconciles. It turns operating assumptions into GAAP or IFRS financials, captures cash consequences, and keeps the balance sheet balanced. Think of it as the accounting spine; valuation, credit work, and deal cases hang off it.

Context and Objective: A Model That Feeds Every Analysis

The model’s purpose is simple: translate drivers into defensible historicals and forward periods. It is not an operating model and not a valuation. Instead, it feeds both by producing clean earnings, cash flow, and capital structure forecasts that tie out.

Start with a closed source pack and version control. Use the latest 10-K or 10-Q for US GAAP filers or IFRS annual or interim reports, earnings materials, and footnotes for segments, revenue recognition, leases, debt, income taxes, share-based compensation, business combinations, and contingencies. Pull the credit agreement and indentures for terms, covenants, baskets, and maturities. Add management guidance, KPIs, and non-GAAP reconciliations. Fix the basis early: currency, units, fiscal year-end, regime, and historical periods (three years plus LTM or TTM). Lock a version 1.0 of historicals, then forecast. Document every reclass with source references.

Model Architecture: A Clean Layout That Audits Fast

Keep structure boring and traceable. When a reviewer opens the workbook, they should guess the layout without a map.

Cover sheet: Purpose, version, date, units, accounting basis.
Assumptions: One sheet for drivers, blue inputs, black formulas, scenario flags and toggles.
Statements: IS, BS, CFS with 2-3 years of history and 5-7 years of forecast.
Schedules: Revenue and margins, OpEx, D and A and PP and E, working capital, debt and interest, leases, taxes and deferred taxes, equity and share count, intangibles and goodwill.
Checks: Balance tests, CFS reconciliation, circularity, roll-forwards, tax reasonableness, sum-of-parts ties.
Outputs: Management KPIs, leverage and coverage, FCF and ROIC.

Use row-consistent formulas, avoid hard-coding, and restrict circularity to interest on cash and revolver sweeps with a toggle. Keep sign convention consistent: expenses and cash outflows negative, assets and liabilities positive, and net change in cash equals ending less beginning. These practices reduce errors and speed audits.

Income Statement Build: Start Clean, Stay Comparable

Revenue: Use segment or product splits if disclosed and separate recurring streams if stable.
COGS: Align shipping, warranty, and distribution with issuer policy to preserve margin comparability.
OpEx: Split SG and A, R and D, and other operating items. Isolate stock-based compensation for visibility.
D and A: Separate depreciation from intangible amortization. Model M and A-driven intangibles separately.
EBIT line: Show interest income, interest expense, and other non-operating items below the line.
Tax and NCI: Use an effective tax rate schedule, then net income with non-controlling interests shown separately.

Normalize nonrecurring items but do not delete them. If management provides adjusted bridges, show them and reconcile to GAAP. Regulators scrutinize adjustments to recurring cash costs, so forecast with care to maintain credibility.

Balance Sheet Build: Group Accounts That Drive Cash

Working capital: Cash, AR, inventory, other current assets, AP, accrued expenses, and other current liabilities. Classify current debt, taxes payable, and lease liabilities correctly.
Long-term assets: PP and E gross and accumulated depreciation, ROU assets, finite and indefinite intangibles, goodwill, equity-method investments, and other long-term assets including DTAs.
Long-term liabilities: Long-term debt, lease liabilities, DTLs, pensions, and other items.
Equity: Common and APIC, retained earnings, AOCI, treasury stock, and NCI.

Add roll-forwards for PP and E, intangibles, goodwill, debt, leases, DTAs or DTLs, and equity. Under US GAAP, net term-debt issuance costs against debt, while revolver costs sit in other assets and amortize to interest expense. That treatment is key for accurate FCF and leverage.

Cash Flow Statement Build: Indirect Method Done Right

Operating: Start with net income, add noncash items like D and A, stock comp, impairment, deferred taxes, amortization of debt costs, lease adjustments, and working capital changes.
Investing: Capex, asset sales, acquisitions net of cash, investments, and intangible additions. Do not invent maintenance versus growth splits without evidence.
Financing: Revolver and term borrowings and repayments, debt costs, dividends, repurchases, equity issuance, tax withholdings on vesting, and lease principal where applicable.

Under US GAAP, interest paid is operating, dividends paid are financing, and dividends received are operating. IFRS allows policy choices. Match issuer policy and keep it consistent so FCF trends are comparable.

Linking Mechanics: Every Movement Has a Home

Retained earnings: Net income rolls in net of dividends.
D and A ties: Link to PP and E and intangible roll-forwards and add back in operating cash flow.
Working capital: Use period-over-period deltas with correct signs.
Interest: Feed IS from debt and cash schedules and classify interest paid in operating cash flow under US GAAP.
Deferred taxes: Tie provision to change in net DTA or DTL adjusted for M and A and OCI.
Leases: Split expense into interest and amortization. Under US GAAP, operating lease principal is a financing outflow.

Supporting Schedules: Drivers That Forecast Well

Revenue: Growth rates, price or volume, capacity, and seasonality if evident.
Costs: Driver-based like headcount times cost per head. Tie to COGS and OpEx.
Working capital: DSO, DIO, and DPO. Forecast via days or turns, not static dollars.
PP and E: Gross and accumulated depreciation, capex, and retirements. Reconcile to footnotes.
Debt and interest: Instrument-level balances, activity, rates, discounts, and cost amortization. Compute interest on average balances to reduce circularity.
Leases: ROU and liability roll, new leases, accretion, amortization, payments. Approximate interest using the weighted average discount rate when data is thin.
Taxes: Statutory rates, permanent differences, discrete items, VA changes, NOL limits. Reconcile forecast ETR to history and statutory anchors.
Equity and shares: Options, RSUs or PSUs, warrants, and buybacks. Model diluted shares with the treasury stock method and sensitivity to price and volatility.

Forecasting Approach: Use the Method Your Data Supports

Top-down: Segment growth from market growth and share.
Bottom-up: Units times price, installed base times churn times ARPU, bookings-to-revenue for software.
Hybrid: Top-down revenue with bottom-up costs and headcount.

Use conservative anchors. Margins drift toward peer medians absent moats. Working capital efficiency reverts to history. Capex scales with revenue or capacity. ETR drifts toward blended statutory rates unless durable attributes exist. Document sources and logic. Flag any assumption that moves more than 10 percent of enterprise value or leverage for extra scrutiny.

For a step-by-step overview, compare your build against this practical guide to building a three-statement financial model and adopt only what your data can justify.

Debt, Cash, and the Revolver Sweep: Funding Without Surprises

Cash policy: Beginning cash plus operating and investing cash yields pre-financing cash. Maintain a minimum cash policy. Use excess to reduce the revolver unless covenants limit it.
Revolver logic: If pre-financing cash is below minimum, draw up to availability or borrowing base. Add a toggle to disable the sweep for tests.
Interest detail: Separate rates for revolver, term loans, bonds, and cash. Include OID and issuance cost amortization.

Illustration: minimum cash 50, pre-financing cash 30, revolver availability 200. Draw 20 to restore cash to 50. Revolver balance rises by 20, interest expense increases by 20 times the revolver rate, and financing cash flows show 20 of borrowings. Include mandatory amortization, springing maturities, and cash sweep terms. For deeper mechanics, see best practices on debt scheduling in financial modeling.

Taxes and Deferred Taxes: Keep It Simple and Auditable

Start with pretax: Use jurisdictional mix if available; otherwise apply a blended rate plus known permanent differences.
Cash taxes: Forecast as ETR-adjusted pretax income plus or minus timing differences, refunds, and audits.
DTA and DTL: Roll forward key categories and tie the net change to the deferred provision.
NOLs: Track limitations, expirations, and valuation allowance rules.

New US disclosure rules under ASU 2023-09 expand rate reconciliation and cash tax detail for fiscal years after December 15, 2024. Plan to update inputs on adoption.

Leases: On-Balance Sheet and Modeled Correctly

Inputs: Opening ROU assets and liabilities, discount rate, remaining term, and maturity tables.
Expense split: Under US GAAP operating leases, total expense is straight-line in OpEx, interest outflow is operating, and principal is financing. Under IFRS, interest sits in financing or operating per policy.
Rolls: Lease liabilities roll opening plus accretion minus principal equals closing. ROU assets roll opening minus amortization plus or minus remeasurements.

Approximate the finance component when needed. Interest is about the average lease liability times the discount rate, and amortization balances to straight-line expense.

Stock-Based Compensation and Dilution: Two Views

Expense: Forecast by grant fair values and vesting or as a stable percent of revenue. Include forfeitures. Add back in operating cash flow with tax effects through APIC under US GAAP.
Dilution: Use the treasury stock method for options and warrants, add probable RSUs or PSUs, and model buybacks with timing. Reflect in weighted-average shares with a mid-period convention.

Cash Flow Edge Cases: Classification That Investors Notice

Debt costs: Cash paid is financing. Amortization runs through interest expense.
Earnouts: Placement depends on the original deal classification. Check the business combination note.
SCF programs: Separate financed payables in working capital metrics and adjust CFS classification if disclosed.
Restricted cash: Reconcile beginning and ending cash, cash equivalents, and restricted cash, and model changes explicitly.

Quality Controls and Circularity: Stability Over Cleverness

Hard checks: BS balances, net change in cash reconciles including restricted cash, and all roll-forwards match activity.
Tie specifics: Interest expense equals weighted average debt times effective rate plus amortization. PP and E and lease rolls tie to capex and maturities. Net DTA or DTL change equals deferred provision after OCI and M and A. NCI earnings and distributions reconcile.
Manage loops: Compute interest on average or prior balances and avoid linking current-period interest to post-sweep cash. If needed, cap iterations and add a switch to freeze interest for sensitivities.

Documentation Map: Faster Diligence When It Counts

Revenue and segments: IS and segment note.
COGS and margins: IS and policy disclosures.
D and A: PP and E and intangibles footnotes.
Working capital: BS and MD and A seasonality.
Debt: Footnotes and credit agreement, including coupon, spreads, maturities, amortization, covenants, and permitted payments.
Leases: Lease footnote.
Taxes: Tax footnote, ETR reconciliation, NOLs, and jurisdictional split.
Equity and SBC: Share-based comp footnote, equity roll-forward, and repurchase authorizations.

Add a source column next to manual inputs with page and paragraph. This cuts diligence time and defuses audit questions.

Outputs by User: Tailor the Dashboard

Private equity: FCF to firm and equity, cash conversion, maintenance versus growth capex, working capital intensity, and exit leverage. Add LBO only after the base model is solid.
Investment banking: EPS, EBITDA, EBIT, FCF, non-GAAP bridges, accretion or dilution, deal pro formas, and growth and margin sensitivities.
Credit: Gross and net leverage, interest and fixed-charge coverage, FCF-to-debt, liquidity runway, covenant headroom using credit agreement definitions with lease adjustments if required.

Implementation Timeline and Owners: One Week to Green

Day 0-1: Source pack, basis, model shell.
Day 2-3: Historicals normalized and PP and E, debt, lease, tax, and equity roll-forwards.
Day 4: Cash flow built and checks pass.
Day 5: Assumptions and forecasts, debt and tax schedules, and revolver sweep.
Day 6: Second-analyst QA, sensitivities, outputs, and a memo on drivers and risks.

Owner map: the lead analyst builds and documents, the associate or VP vets assumptions and ties to the thesis, counsel interprets covenants, and the controller or FP and A confirms accounting and one-offs.

Pitfalls and Kill Tests: Stop Fast and Fix

Immediate stop: If historical CFS will not reconcile within two hours.
Confirm first: Reconcile D and A and interest to footnotes before forecasting.
Reclass check: Revisit working capital if days swing without a driver.
Frequent errors: Mixing IFRS and US GAAP policies across periods, double-counting D and A across COGS and OpEx, misclassifying debt costs, ignoring stock comp tax effects, omitting lease balances, misplacing NCI, and hard-coding dividends or buybacks that breach baskets.

Cash Waterfall: Legal Priority in the Model

Sequencing: Operating cash funds maintenance and committed growth capex, then interest and lease principal, then mandatory amortization and revolver sweeps.
Residual uses: Buybacks, M and A, and dividends, all subject to covenants.
Controls: Build minimum liquidity triggers and covenant dials so the waterfall respects legal constraints.

Small Illustration: A Quick Tie-Out

EBITDA 100, D and A 30, EBIT 70, interest 15, pretax 55, ETR 25 percent so tax 14, and net income 41. Add-backs of D and A 30 and stock comp 5 yield operating cash before working capital of 76. Working capital of AR plus 10, inventory plus 5, and AP plus 7 equals a net outflow of 8. Cash from operations is 68. Capex is 35. FCF to firm is 33. Financing includes term amortization of 10 and buybacks of 5. Net change in cash is plus 18. Balance sheet ties follow: cash up 18, PP and E up by capex less depreciation, debt down 10, and equity up by net income and down by buybacks.

Accounting and Reporting: Model the Regime, Not Your Preference

Consolidate only subsidiaries. Equity-method investees flow via a one-line pickup, with dividends in investing cash flows under US GAAP. For business combinations, separate purchase accounting from operations and build a pro forma stub if the deal closes mid-year. If derivatives are material, add a simple mark-to-market schedule and tie cash and OCI per hedge accounting rules. Model required disaggregation under ASC 606 or IFRS 15 and the tax disclosure expansion to the extent they sharpen the forecast.

Governance and Closeout: Make It Defensible

Lock and archive each major version, protect sheets, and define input ranges. Keep a change log and the rationale for assumption shifts. Make the model explainable. You should be able to walk from revenue to cash in five minutes at a whiteboard. At closeout, archive the workbook, index, versions, and change log, hash the final file, and apply retention policy. If a third party holds any copy, request deletion and a destruction certificate. Legal holds override deletion.

Practical Shortcuts When Rushed: Speed Without Sloppiness

Days-based WC: Use DSO, DIO, and DPO drivers.
ETR proxy: Apply a blended rate anchored to history, then refine.
Leases as pool: Use weighted-average rate and term.
Interest timing: Compute interest on beginning debt for sensitivities to avoid loops.
Capex guardrail: Set capex as a percent of revenue or of depreciation with a minimum to preserve capacity.

Original Angle: A Lightweight QA Stack That Saves Hours

Beyond standard checks, add a lightweight QA stack. First, create a one-sheet audit report that scores each period on BS balance, CFS match, and schedule tie-outs. Second, export statement deltas and run a short Python script to rebuild the indirect CFS from balance sheet movements and noncash items, then compare to your CFS. Third, use named ranges and Excel’s Watch Window to flag broken links when toggling scenarios. A simple rule of thumb helps: you should rebuild operating cash flow from net income with fewer than a dozen add-backs and working capital lines, or your mapping may be too granular to maintain.

What Good Looks Like: Tight, Verifiable, Dull

Historical tie: Periods match filings with transparent reclasses and no plug other than cash.
Controllable drivers: Forecasts use levers the business can influence.
Traceability: You can source any material line quickly.
Sensitivities: The two or three assumptions that move value or covenants jump off the page.
Cash logic: Cash and the revolver move for operational reasons, not formula quirks.

Key Takeaway

If you keep the three-statement model tight, verifiable, and dull in the best way, it will do its job: a straight story from earnings to cash and a forecast that survives a tough diligence call.