Projecting the three statements in a financial model is crucial for several reasons, such as preparing a comprehensive financial forecast for a company to assess expected financial performance, undertaking financial planning to help make operational decisions and investment plans, doing investment and valuation analysis to assess the potential return on investment and preparing a liquidity and debt management plan for the company to assess its risk profile.
Let’s examine how to create a “three-statement projection model” for a company by estimating its cash flow, cash and debt balances over the years. Here’s a structured approach broken down into six simple steps.
Step 1: Forecast revenue in detail
Start by projecting revenue based on historical data, market trends and growth assumptions. Analyze sales volume, pricing and market conditions to develop a detailed revenue forecast. Broadly, you can project revenue using three main approaches:
- By applying a simple percentage growth rate
- Bottom-up by calculating the number of units sold times the average price per unit
- Top-down by calculating the company’s market share times its market size
Step 2: Estimate expenses and/or margins
Project future expenses, including cost of goods sold, operating costs and other relevant expenditures. Typically, expense projections are less detailed than revenue forecasts.
For instance, if a company’s operating margin has increased from 10% to 11% historically, you might project a continued upward trend, estimating it to reach 12% in the coming years. In more intricate models, you could link expenses to specific factors such as individual employees, units sold, production facilities or other relevant assumptions to refine the projections.
Step 3: Forecast operational balance sheet items and connect them to the cash flow statement
Project key operational balance sheet items such as accounts receivable, inventory and accounts payable. Typically, revenue-related items are linked directly to the company’s revenue. For instance, accounts receivable and deferred revenue are often expressed as percentages of revenue, reflecting historical trends and patterns. Ensure these projections are linked to the cash flow statement, as changes in these items will affect cash flow.
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Step 4: Estimate other cash flow statement components
After projecting the operational balance sheet items and linking these changes to the cash flow statement, the next step is to forecast the remaining cash flow statement line items such as capital expenditures (CapEx) and debt.
Some of these projections might be based on straightforward percentages, while others may require detailed schedules. For example, for industries such as airlines, manufacturers or railroads, where CapEx is significant, creating a separate schedule for CapEx is often beneficial. Make sure these projections align with the operational forecasts and accurately reflect expected cash flows.
Step 5: Integrate interest expenses and balance sheet items
Include interest expenses in the income statement and ensure that all balance sheet elements, such as debt and equity, are correctly incorporated and linked to the financial projections.
Step 6: Compile summary statistics
Gather and analyze key financial metrics and summary statistics from the projections. This includes profitability ratios, liquidity measures and leverage ratios, which help evaluate the company’s financial health and performance. The focus of a financial model varies based on its intended purpose. Here are a few examples:
- Credit analysis. When evaluating a company’s ability to repay its debt, you would focus on credit-related ratios such as debt to EBITDA, EBITDA to interest and the debt service coverage ratio.
- Equity investment analysis. For assessing potential equity investments, you would look at metrics such as the internal rate of return and money-on-money multiples.
- Valuation. In a valuation context, key metrics include the company’s revenue, EBITDA, cash flow, growth rates and profit margins.
- M&A analysis. When analyzing mergers and acquisitions, you would concentrate on growth rates, earnings per share and other per-share metrics to understand how these figures might be affected by the deal.
The above framework provides a step-by-step structure on how to project a financial model for a company and is a good starting point. Ultimately, the best method for projecting the three statements depends on multiple other factors such as the company’s industry, how much data and time are available and the purpose and intended audience of the analyses.
