THREE STATEMENT MODEL

THREE STATEMENT MODEL

A three statement model links the income statement, balance sheet, and cash
flow statement into one dynamically connected financial model. Three statement
models are the foundation on which more advanced financial models are built.

A well-built 3-statement financial model helps insiders and outsiders to see how the
various activities of a firm work together, making it easier to see how a decisions impact
the overall performance of a business.
 
INCOME STATEMENT
An income statement is one of the financial statements of a company and shows the
company's revenues and expenses during a particular period. It indicates how
the revenues are transformed into the net income or net profit.
BALANCE SHEET
A balance sheet is a financial statement that reports a company's assets, liabilities and
shareholders' equity at a specific point in time. It is a financial statement that provides a
snapshot of what a company owns and owes, as well as the amount invested by
shareholders.

CASH FLOW STATEMENT

A cash flow statement is a financial statement that provides aggregate data regarding all
cash inflows a company receives from its ongoing operations and external investment
sources. It also includes all cash outflows that pay for business activities and investments
during a given period.
 DCF MODEL
The Discounted Cash Flow Model is used to determine the present value of the companies forecasted
future cash flow , companies typically use weighted average cost of capital as the discount rate to arrive at
the present value as it takes in consideration the rate of return expected by the shareholders.
If the discounted cash inflows value is greater than the present value of the outflow indicates that the
opportunity would result in positive returns to the company ,whereas, if the present value of cash inflow is
less than the present value of the outflow indicates that the opportunity would result in negative returns.
The formula for DCF is:
DCF = CF1/(1+r)1+ CFn /(1+R)N
where:
CF is the cash flow for the current year.
CF1 is for year one,
CFn is for additional year
R is the discount rate
Example-
You are looking to invest in a project and your company's WACC is 5%,the initial investment
required for the project is $11 million and the project will last for five years, with the following
estimated cash flows per year:

We will discount the cash flows with the WACC to get present value of cash flows
Therefore, the discounted cash flows for the project are:

If we sum up all of the discounted cash flows, we get a value of $13,306,749 million. The initial
investment of the project is $11 million, we subtract present value of inflows by present value of
outflow, we get a net present value  (NPV) of $2,306,749 million.
As this is a positive number, the cost of the investment today is worth it as the project will generate
positive returns . If the project had cost $14 million, the NPV would have been -$693,251 million,
indicating that the cost of the investment would not be worth it as returns would be negative.
 UNLEVERED CASH FLOWS
Unlevered free cash flow (UFCF) is the free cash flow available to pay all stakeholders in a firm,
including debt holders and equity holders, i.e.  It is the money the business has before paying its
financial obligations.

The formula for UFCF is

UFCF = EBITDA - CAPEX - change in working capital – taxes

Where:
Earnings before interest, taxes, depreciation, and amortization: EBITDA is an alternative to
simple earnings or net income that you can use to determine overall financial performance.
Capital expenditures: CAPEX are investments in property, buildings, machines, equipment, and
inventory, as well as accounts payable and accounts receivable.
Working capital: the total current assets less total current liabilities.
Taxes: the amount owed in taxes.
Example:
Company ABC has EBITDA of $450,000. The company purchased capital assets worth$275,000,
Expense on working capital for the year was $50,000 and Taxes due for the year were $25,000.

With all of the information given in the table we can calculate UCFC as follows :
UFCF = 450,000 - 275,000 - 50,000 - 25,000 = $100,000
We can conclude from above that company ABC has $100000 before paying its financial
obligations.
 LEVERED CASH FLOWS
Levered cash flow is the amount of cash a business has after it has met its financial obligations
Levered free cash flow is important to both investors and company management, because it is the
amount of cash that a company can use to pay dividends to shareholders and/or to make further
investments in growing the company's business
Levered free cash flow formula
LFCF = EBITDA – Mandatory Debt Payments – Change in Net Working Capital - Tax– Capital
Expenditures
Where:
EBITDA – This stands for earnings before interest, taxes, depreciation and amortization
Mandatory Debt Payments – This is everything a company owes to debtors.
Working Capital – This refers to the total amount of working capital that a company has available to it.
Capital Expenditures – These are investments in fixed assets made by a company, such as land,
buildings, or equipment.
Example:
You started company ABC was started three years ago and you invested $100,000 of your own
money and borrowed an additional $200,000. Each month, you owe a minimum of $10,000 on that
debt.
In the first year, your EBITDA was $550,000. Capital assets were purchased Year 1 for $275,000,
working capital expense was $50000

LCFC = 550,000 - 50,000 -25000- 275,000 - 120,000 = $80,000

We can conclude that ABC has $80000 after meeting their financial obligations.
 FREE CASH FLOW TO FIRM
Free cash flow to the firm (FCFF) is the cash available to pay investors after a
company pays its costs of doing business, invests in short-term assets like inventory,
and invests in long-term assets like property, plants and equipment. The firm's
investors include both bondholders and stockholders.
FCFF formula
FCFF = Cash Flow From Operations + Interest Expense * (1 – Tax Rate) – Capital
Expenditures (CAPEX)

Example:
company XYZ has done sales worth $100,operating cost incurred was
$20,Depriciation amounted to $20 ,Interest payment made was $30 for the year
,Taxes for the year was $12,Working capital investment was $10 and CAPEX was $10
 FREE CASH FLOW TO EQUITY
Free cash flow to equity (FCFE) is the amount of cash a business generates that is available to be
potentially distributed to shareholders.
FCFE formula
FCFE = EBIT – Interest – Taxes + Depreciation & Amortization – ΔWorking Capital – CapEx + Net
Borrowing
FCFE = FCFF – Interest expense * (1 – tax) + Increase in debt
Where:
FCFE is Free Cash Flow to Equity
EBIT is Earnings Before Interest and Taxes
ΔWorking Capital is Change in the Working Capital
CapEx is Capital Expenditure
Example
Company A has net income $200million and A’s balance sheet and income
statement is as follows

FCFE = 200$ + $15 –$50 -$50 + $20 = $135

 TERMINAL VALUE
Terminal value is the value of a project at some future date beyond which more precise
cash flows projection is not possible. It is also called horizon value or continuing value
Terminal Value is the present value of all future cash flows, with the assumption
of perpetual stable growth.
A perpetuity is a type of annuity that lasts forever, into perpetuity. The stream of cash
flows continues for an infinite amount of time.

Formula for calculating Terminal Value:

EBITDA × Benchmark EV/EBITDA ratio
Example

You works as a financial analyst ,you have to make precise year on year projections for next
5 years. From 6th year onwards a growth rate of 3% is built into the model forever.
Free cash flow at the end of 6th year is expected to be $2 billion. The applicable required
rate of return is 11%. Companies EBITDA for 6th year is $6 billion, and average EV/EBITDA
multiple that prevails in the industry is 4.5.

TV = EBITDA × Benchmark EV/EBITDA ratio
= $6 billion × 4.5
= $27 billion
 WEIGHTED AVERAGE COST OF CAITAL
Weighted average cost of capital is the average rate of return a company is
expected to pay to all of its shareholders; which includes, debt holders, equity
shareholders and preferred equity shareholders; who have a different rate of return
each because of the pecking order and hence the difference in weighted average
cost of capital
Example

WACC Formula = E/V * Ke + D/V * Kd * (1 – Tax)

V=MARKET VALUE OF EQUITY + MARKET VALUE OF DEBT

Weighted average cost of capital =

$300000/500000 * 0.04 + 200000/500000 * 0.06 * 0.65 = 0.0396 = 3.96%.