How to Use Financial Statements in Financial Modeling?
What Are Financial Statements?
Financial statements are written records that convey the business activities and the financial performance of a company. Government agencies, accountants, firms, etc. are the ones who often audit the financial statements. The main goal is to ensure accuracy and for tax, financing, or investing purposes. Three main financial statements include:
Cash flow statement.
Let’s take a look at each statement in more details.
What is an Income statement?
An income statement (profit and loss account) is one of the financial statements of a company. It shows the company’s revenues and expenses during a particular period. In addition, It indicates how we transform the revenues into the net income or net profit. Often, the first place an investor or analyst will look at is the income statement. Here are some highlights:
Shows the revenues and expenses of a business
Expressed over a period of time (i.e., 1 year, 1 quarter, Year-to-Date)
Used to assess profitability.
What is a Balance sheet?
The balance sheet displays the company’s total assets, and how these assets are financed, through either debt or equity. Also, we can refer to it as a statement of net worth or a statement of financial position. Here are some highlights:
Shows the financial position of a business
Expressed as a “snapshot” or financial picture of the company at a specified point in time
Based on the fundamental equation: Assets = Liabilities + Shareholders Equity.
What is a cash flow statement?
The cash flow statement reports the cash generated. We use it during the time interval specified in its heading. Generally, the period of time is the same as the income statement. Here what you have to remember:
Shows the increases and decreases in cash
Expressed over a period of time, an accounting period (i.e., 1 year, 1 quarter, etc.)
Undoes all accounting principles to show pure cash movements
Has three sections: cash from operations, cash used in investing, and cash from financing.
How do we use these financial statements in financial modeling?
Financial models use the trends in the relationship of information within these statements. In addition, it uses the trend between periods in historical data to forecast future performance. Here are the steps to follow to create a financial model:
Set up the line-items for each of the core statements. This provides the overall format and skeleton that the financial model will follow.
Place the historical numbers in each of the line-items.
Prepare an assumption section within the sheet to analyze the trend in each line-item of the core statements between periods.
Then, we use the assumptions from existing historical data to create forecasted assumptions for the same line items.
The forecasted section of each core statement will use the projected assumptions to populate values for each line item.
The picture below is an example of the simple one-sheet model using information from all three financial statements. The best practice is to build a simple model in quadrants (shown below). You can learn more about Financial modeling best practices in our article.
A 3-statement financial model is a type of model that forecasts a company’s income statement, balance sheet, and cash flow statement. These are usually on separate Excel sheets. Above all, a key feature of an effective model is that it is “integrated”. In other words, we model the 3-statement models to accurately capture the relationship and inter-linkages of the various line items across the financial statements. Moreover, an integrated model is powerful because it enables the user to change an assumption in one part of the model. The reason is to see how it impacts all other parts of the model consistently and accurately.
All three accounting statements are important for understanding and analyzing company performance. It helps to visualize the situation from multiple angles. For instance, The income statement provides deep insight into the core operating activities that generate earnings for the firm. However, the balance sheet and cash flow statement focus more on the capital management of the firm. It refers in terms of both assets and structure.
To sum up, The three main financial statements are the core for building any financial model of the company. Learn more of Financial Modeling skills and needed for that Excel tricks by playing our educational games keySkillset.