How Do You Build a Complete Three-Statement Model?

A three-statement model is the backbone of nearly every financial model used in investment banking. It links the income statement, balance sheet, and cash flow statement into one dynamic file, allowing the user to test assumptions and immediately see the full financial impact. Without a functioning three-statement model, it is not possible to build a reliable DCF, LBO, or M&A model.

This article explains how to construct and link the three financial statements — step by step — in a way that is transparent, consistent, and ready for use in real transaction work.

What Is a Three-Statement Model?

A three-statement model is a financial model that projects the income statement, balance sheet, and cash flow statement and links them together through internal logic.

It starts with the income statement, where revenue, expenses, and net income are forecasted. These outputs feed into the balance sheet through retained earnings, working capital, and non-cash items. The cash flow statement then reconciles net income to actual cash movements, showing how the business generates and uses cash.

The purpose of the model is to show a complete financial picture of the company under a specific set of assumptions. Each statement must be consistent with the others. If one input changes — such as revenue growth or capex — the impact should automatically flow through all three statements.

This integration is what makes the model a powerful decision-making tool.

Forecasting the Income Statement

The income statement is usually the first part of a three-statement model to be built. It shows how revenue becomes net income, passing through the company’s cost structure and tax position.

The forecast typically includes the following line items:

1. Revenue — projected based on volume and price, growth rates, or segment-level inputs.
2. Cost of Goods Sold (COGS) — often linked to revenue through gross margin or cost ratio.
3. Gross Profit — revenue minus COGS.
4. Operating Expenses — SG&A, R&D, or other overhead, forecasted as fixed amounts or % of revenue.
5. EBITDA — earnings before interest, taxes, depreciation, and amortization.
6. Depreciation and Amortization — linked to capex and asset schedules from the balance sheet.
7. EBIT (Operating Income) — EBITDA minus D&A.
8. Interest Expense and Income — depends on projected debt and cash balances.
9. Pre-Tax Income — EBIT minus net interest.
10. Taxes — usually based on a normalized tax rate unless a detailed tax schedule is required.
11. Net Income — the final result, which flows into the equity section of the balance sheet and the top line of the cash flow statement.

Each of these line items should be clearly linked to assumptions or supporting schedules. The forecast should follow the company’s real reporting structure, with segment or regional breakdowns if available.

A clean income statement forecast sets the foundation for the rest of the model. All changes — from growth assumptions to financing — will flow through this section first.

Forecasting the Balance Sheet

The balance sheet captures the company’s financial position at a point in time — what it owns, what it owes, and what remains for shareholders. In a three-statement model, it must be fully linked to the income statement and cash flow statement so that every change flows through the financials consistently.

The forecasted balance sheet typically includes the following sections:

Assets:

• Cash and Equivalents — updated from the cash flow statement.
• Accounts Receivable — forecasted as a percentage of revenue or in days sales outstanding.
• Inventory — linked to cost of goods sold or turnover assumptions.
• Prepaid Expenses and Other Current Assets — usually modeled as a % of revenue.
• Property, Plant & Equipment (PP&E) — linked to historical net balance, capex, and depreciation.
• Intangibles or Goodwill — may stay flat unless there is an acquisition assumption.

Liabilities:

• Accounts Payable — forecasted as a percentage of COGS or in days payable outstanding.
• Accrued Expenses and Other Current Liabilities — often tied to revenue or SG&A.
• Short-Term and Long-Term Debt — linked to the financing assumptions and debt schedule.
• Deferred Taxes or Other Liabilities — can be held constant or forecasted if more detail is required.

Equity:

• Common Stock & APIC — usually held flat unless issuing new equity.
• Retained Earnings — updated by adding net income and subtracting dividends.
• Other Equity Items — such as treasury stock or accumulated other comprehensive income, may be held flat unless relevant to the transaction.

The goal is to maintain balance: Assets = Liabilities + Equity. Each line must connect logically to the model's assumptions and to the outputs from the income and cash flow statements.

Forecasting the Cash Flow Statement

The cash flow statement reconciles net income to actual cash movement. In a three-statement model, it ensures that changes in non-cash items and balance sheet accounts are captured, and that ending cash flows into the balance sheet correctly.

The standard format used in investment banking is the indirect method, which starts with net income and adjusts for non-cash and working capital items. It has three main sections:

1. Cash Flow from Operating Activities

• Start with Net Income (from the income statement)
• Add back non-cash expenses like depreciation and amortization
• Adjust for changes in working capital:
  • Increase in receivables = use of cash
  • Increase in payables = source of cash
• Result: cash generated from core operations

2. Cash Flow from Investing Activities

• Capital Expenditures (capex) — typically the largest use of cash in this section
• Asset sales or acquisitions, if any
• Result: net cash used for or generated by investment

3. Cash Flow from Financing Activities

• Debt issuance or repayment — linked to the debt schedule
• Equity issuance or repurchase, if modeled
• Dividends paid — usually subtracted from retained earnings
• Result: net cash from or used in financing

The net change in cash is added to the beginning cash balance (from the previous year) to calculate ending cash, which flows directly into the balance sheet.

This statement ensures the model reflects actual cash generation and use — and ties together all the moving parts across the income statement and balance sheet.

Linking the Statements Together

What makes a three-statement model powerful is not just the individual forecasts — it's the fact that all three statements are fully linked. This means that a change in one part of the model automatically updates the others, maintaining consistency across the entire financial picture.

Here are the most critical linkages:

1. Net Income Flows into Retained Earnings
Net income from the income statement increases retained earnings in the equity section of the balance sheet. If dividends are paid, they reduce retained earnings accordingly.

2. Depreciation Affects Multiple Statements
Depreciation is added back on the cash flow statement (non-cash expense), subtracted in the income statement, and reduces the PP&E balance on the balance sheet.

3. Capital Expenditures Impact PP&E and Cash
Capex is a use of cash in the cash flow statement and increases the PP&E balance on the balance sheet.

4. Working Capital Changes Link Income, Cash Flow, and Balance Sheet
Changes in accounts receivable, inventory, and payables show up on the cash flow statement and also adjust the corresponding balance sheet items. These changes affect the company’s cash needs even if reported earnings remain unchanged.

5. Debt and Interest Are Interconnected
Debt levels drive interest expense in the income statement. Principal repayments and new borrowings appear in the financing section of the cash flow statement and adjust the debt balance on the balance sheet.

6. Ending Cash Balances Must Match
The final line of the cash flow statement (ending cash) flows directly into the “Cash and Equivalents” line of the balance sheet for the same year.

Each of these links ensures that the model functions as a single, integrated system. A properly linked model allows analysts to test assumptions and immediately see how the full set of financials respond — without errors or inconsistencies.

Handling Circular References

Circular references happen when one part of a model depends on another, which in turn depends on the first. In a three-statement model, this usually occurs when interest expense is linked to debt balances, and those debt balances are adjusted based on cash flow — which already includes interest expense.

These loops are common in integrated models, but they must be managed carefully to avoid instability or errors.

How Circularity Happens:

• Interest expense is calculated based on average debt.
• Cash flow from operations is reduced by interest paid.
• Ending cash (after financing) affects how much new debt is needed.
• That new debt updates the debt balance, which changes the interest expense again.

This creates a loop.

How to Handle It:

1. Use an Iterative Calculation Setting
   In Excel, enable “iterative calculations” under File > Options > Formulas. This allows the model to converge on a solution after several recalculations.
2. Control the Loop with a Switch
   Some models use a toggle (on/off switch) to run with or without circular interest. This can be useful for reviewing or troubleshooting.
3. Use an Approximation
   Instead of linking interest to dynamic debt balances, some models fix interest to a base case debt level. This avoids the loop and is often sufficient for presentation purposes.

Best Practice:
If your model uses circular references, make them visible and controlled. Never hide circularity or assume it won’t affect your outputs — especially when working in teams or sharing files with clients.

Checks and Balances

A working model is not enough — it also has to be correct. That’s why every professional three-statement model includes built-in checks to ensure accuracy, consistency, and auditability.

Here are the standard checks used in banking models:

1. Balance Sheet Balances
The most basic check: total assets must equal total liabilities plus equity. If this fails, it usually means a linking error or a missing item in one of the schedules.

2. Cash Flow Reconciles Ending Cash
The ending cash balance from the cash flow statement should match the cash line on the balance sheet — exactly. If not, something in the linking logic is off.

3. Depreciation and Capex Tie Across Statements
Depreciation should match between the income statement, cash flow statement, and PP&E roll-forward. Capex should do the same.

4. Working Capital Flows Are Consistent
Changes in receivables, inventory, and payables must tie across the balance sheet and cash flow statement. Direction and signs must align.

5. Debt Schedules Match the Balance Sheet
The total debt in the debt schedule must tie to the balance sheet — both for short-term and long-term portions. Any interest calculation should use these same values.

6. Model Flags or Error Messages
Some models include simple logic tests — such as flagging negative equity, abnormally high margins, or negative cash balances — to alert the user before sending out the file.

Including these checks protects the integrity of the model and reduces the risk of sharing incorrect information with clients or internal teams.

Closing Thought

A three-statement model is the foundation of professional financial analysis. When structured and linked correctly, it becomes a flexible tool for valuation, scenario testing, and decision-making. In investment banking, a clean, functional model is not just expected — it's essential. It reflects the analyst’s attention to detail, discipline, and understanding of how the financials fit together.