How to Build a 3-statement Model: Best Practices for Valuations and Projections

Knowledge—correct, data-based, properly interpreted information—is indeed power, and the lack of it can cost businesses millions. In particular, accurate company valuations and projections of free cash flow available to equity holders are crucial, not just during mergers and acquisitions, but at all times if leaders and prospective investors are to understand a company’s current and future financial standing. Many companies use only a projecting income statement to forecast what’s coming, but that can lead to dramatically inaccurate projections and valuations. That's why I recommend using the gold standard financial model: a three-statement model incorporating the balance sheet, cash flow statement and income statement.

Why Accurate Financial Projections Are Essential

Financial projections are useful for business leaders who are planning and budgeting for the near term and forecasting their company’s performance under a variety of conditions. They also help identify investment needs and assist in valuing the business. For example, projected surpluses suggest new opportunities for reinvestment, where projected shortfalls may indicate a need for retrenchment or course changes. Conversely, investors use financial projections to challenge the assumptions behind a prospectus or business forecast.

Projections are also essential inputs to valuation formulas. Valuations are crucial for mergers and acquisitions, as well as for developing contingencies and to aid in decision analysis. When leaders are considering a major investment decision or change of direction, modeling the effect of those choices on future valuation may help guide the choice. Once executed, major enterprise decisions require accurate before-and-after valuations to assess the value of those changes.

The most common valuation technique is discounted cash flow (DCF). When DCF is used with just an income statement, as it often is, it uses income as a proxy for cash flow. This works well enough when working capital—the metric of liquidity that represents the difference between the company’s current assets and current liabilities—is neutral or its absolute value is small compared to cash flow based on income. But when working capital is high relative to income, this method can fail to identify significant cash inflows or outflows.

That’s because working capital can have significant effects on cash flow that the income statement doesn’t capture. As a valuation advisor for KPMG, I’ve created three-statement financial models for clients seeking to raise funds and value acquisition targets. My experience has taught me that performing DCF using all three statements provides the most accurate results and will serve you best, no matter what your goal is.

What the Income Statement Leaves Out

The biggest pitfall for financial analysts performing projections is treating the income statement as if it represents cash flow.

The income statement focuses solely on profit and loss. While you naturally tend to think the more profitable a company is, the better, there’s more to valuation than an isolated dollar value. First, not all sales are collected as cash. Some sales are made on credit and recorded as accounts receivable. Second, not all cost of goods sold (COGS) is cash outflow. Some of these costs will be covered by purchases that the business makes on credit. Because these transactions (changes in accounts receivable and accounts payable) aren’t recorded on the income statement, a forecast that relies only on this statement doesn’t give the full picture of the cash inflows and outflows of a business.

Three-statement models incorporate all the important facets of a business’s operations. These models project—along with other balance sheet items—forecasted balances of working capital elements such as accounts receivables, inventory, and prepaid expenses. Together, these influence the free cash flows available for the business’s operations. This matters because a company with high working capital demands can seem profitable on the surface but actually be in the red once the cash flows are laid bare.

How Building a 3-statement Financial Model Benefits Business Leaders

A company’s value isn’t always readily apparent to its leaders. I was once asked to build a three-statement financial model and valuation study for a greenfield aluminum recycling facility. The CEO was certain the facility was profitable, given the significant EBITDA margins reflected in the income statement. She was surprised to see that the valuation result came back below her expectations.

The facility was turning a high sales volume: Scrap aluminum was purchased with cash, recycled within the facility, and sold on two-month terms. Consequently, it took a lot of cash outflow to fund the working capital needs of the operations. This information didn’t appear in the income statement and could only be found in the cash flow statement, which details the movement of cash and cash equivalents in and out of a business.

Focusing only on the income statement and profitability would have resulted in the CEO missing this important aspect of her business. Drawing on the insights of a three-statement model, she was able to prepare for working capital cash outflows in the future by adding the startup working capital requirement as a project cost when asking for financing.

The implications here are clear: Even when leaders aren’t considering an exit, they need to know exactly how much their businesses are worth, how much they’re going to earn, and how much it will cost to operate them. Had I used a single-statement-based valuation that confirmed her biases, the CEO might have been in for a nasty shock down the road.

How Building a 3-statement Financial Model Benefits Investors and Buyers

Three-statement models are also useful for potential investors or purchasers doing due diligence. These models allow investors to look past profitability and assess the cash yield of a potential investment. Even when a company is profitable and growing, it may lose cash because of high working capital requirements. This is especially true for companies with low profit margins, high sales volume, and positive working capital projections. The most common example of this is industrial companies, since they often have large sums of cash tied up in working capital.

The opposite situation is also possible. A company may be earning a very slim margin but have negative working capital, in which case sales growth brings cash flow into the business. This is often the case for businesses in the retail sector and for utilities.

In both cases, it’s critical for investors to run working capital sensitivity analyses using the elements of the cash conversion cycle—days sales outstanding (DSO), days payable outstanding (DPO), and days inventory outstanding (DIO)—on the projections. These findings can lead to improvements in working capital management, which then allows the business to free up cash for investments. However, these analyses are only possible when the underlying financial model has the capacity to calculate future balance sheet items—in other words, a three-statement model.

I once conducted financial due diligence on an Eastern European building-chemicals company in an acquisition deal. Riding on the back of the booming construction sector, this target company was highly profitable. A one-statement model probably would have produced a healthy valuation. But when I built a three-statement model for the business, it became clear that it was polishing its profitability by loosening its trade terms—selling its products at a higher price, but giving customers more time to pay.

Although this tactic increased the company’s profitability, it forced the business to tie up a significant amount of cash in working capital, reducing liquidity. The cash outflow required to fund the working capital devalued the company significantly. This problem wasn’t identified until we created a three-statement model and looked closely at cash movements in the projections.

A 3-statement Model Example

To illustrate how single-statement DCF can lead to a significantly inaccurate result, I’ve created two alternative projections for a fictional company called Vermont Telecom. Telecom companies typically have high working capital requirements: They collect plan payments monthly or yearly, and those add up to billions of dollars and cover operational and capital expenditures. Any fluctuation in their operating cash cycle has a significant effect on their valuation and cash position. They usually borrow short-term funding to cover gaps in their cash cycle.

These excerpts from a discounted cash flow analysis show the dramatic difference between projecting present value of free cash flow in DCF using just an income statement and using a three-statement model that includes working capital.

Discounted Cash Flow Analysis: Present Value of Free Cash Flow Using Income Statement Only

As you can see, the single-statement approach shows no information for the increase in net working capital. But for Vermont Telecom, with its high working capital needs, that value is actually quite significant. Here’s what it looks like when you incorporate the working capital requirements of the business:

Discounted Cash Flow Analysis: Present Value of Free Cash Flow Using 3-statement Model

The increase in net working capital is -$98.5 million in 2022, which results in a multimillion-dollar difference in the final value of free cash flow in the three-statement model compared to the single-statement analysis.

Moving on to valuation, as you can see here, a single-statement DCF without working capital substantially overvalues the enterprise with a central projection value of $602 million based on weighted average cost of capital (WACC) at 15% and a terminal growth rate of 2.5%.

Enterprise Value Using Income Statement Only

When working capital is factored into the equation, the same assumptions result in a valuation of only $483 million—a substantial 22% difference.

Enterprise Value Using 3-statement Model

Best Practices for Handling Working Capital in a 3-statement Model

There are a variety of methods you can use to ensure that your financial model accurately projects the working capital lines. The approach I prefer is also the most common one: using days working capital—how many days it takes to convert working capital into revenue. Standard practice suggests we take the average of historical days working capital or use peer group averages.

Let's say you have the sales and cost of goods sold projected and you chose to use average days working capital. Combing this data, you can calculate 2023 working capital values in the balance sheet as follows:

• 2023 Accounts Receivable Balance Forecast = (DSO / 365) * (2023 Sales Forecast)
• 2023 Accounts Payable Balance Forecast = (DPO / 365) * (2023 COGS Forecast)
• 2023 Inventory Forecast = (DIO / 365) * (2023 COGS Forecast)

The sum of these three lines will let you arrive at your working capital projections for the coming year.

The Power of 3

As I’ve demonstrated, performing DCF valuation using just the income statement to approximate cash flow can lead to serious problems when the value of working capital, whether positive or negative, is significant. Developing a three-statement model rectifies these problems, and it provides a more nuanced and accurate view of the enterprise.

But there are additional benefits as well. Three-statement modeling enables other more advanced forms of analysis. For example, Harvard Business Review recommends combining DCF with real option analysis to achieve a median value when major investment decisions are being evaluated. Three-statement modeling also serves as the basis for models used for M&A, scenario planning, and sensitivity analysis.

It’s always empowering to have a full picture of your business, whether you’re seeking an exit or an investment, or you simply want to make informed choices about your company’s growth. Three-statement modeling is more time-consuming and requires more expertise to build, but in the long run, it’s well worth it.