Building a simple three-statement model: how the P&L, balance sheet and cash flow link

A three-statement model links a company’s profit and loss account (P&L), balance sheet and cash flow statement so that a change in one flows through to the other two. Change the sales forecast and you see the effect on profit, on the cash in the bank and on what the business owns and owes. It is the base layer under most budgets, fundraising forecasts, lending cases and valuations.

You do not need complex software to build one. A spreadsheet and a clear grasp of how the statements connect is enough. This guide explains the links, then builds a one-year example by hand so you can see that it balances.

What each statement shows

• The P&L shows performance over a period: revenue, costs and the resulting profit. It uses accrual accounting, so a sale counts when it is made, not when the customer pays.
• The balance sheet is a snapshot at a point in time: what the business owns (assets), what it owes (liabilities) and what belongs to the owners (equity). Assets always equal liabilities plus equity.
• The cash flow statement explains how the cash balance moved between two balance sheet dates, split into operating, investing and financing activities.

The P&L and cash flow statement cover a period. The balance sheet sits at the start and end of that period, and the other two explain how it changed.

The links that hold it together

A handful of connections do most of the work.

1. Net profit from the P&L becomes the first line of the cash flow statement (under the indirect method) and is added to retained earnings on the balance sheet.
2. Depreciation reduces profit on the P&L but is not a cash cost, so it is added back on the cash flow statement. It also reduces the value of fixed assets on the balance sheet.
3. Changes in working capital (receivables, stock and payables) on the balance sheet appear as adjustments in operating cash flow. More money owed by customers means less cash. More money owed to suppliers means more cash, for now.
4. Capital expenditure increases fixed assets on the balance sheet and appears as an outflow in investing cash flow.
5. Borrowing and repaying debt changes the debt balance and appears in financing cash flow. Interest on that debt goes to the P&L.
6. Dividends reduce retained earnings and appear in financing cash flow.
7. Closing cash from the cash flow statement becomes the cash line on the closing balance sheet.

If all of these are linked correctly, the balance sheet balances without any plugging. If it does not balance, one of these links is broken.

A worked example

An example (illustration only): a small business starts the year with this balance sheet (all figures in £000).

Assumptions for the year: revenue 500, cost of sales 300, overheads 120, depreciation 20, interest 5 and an assumed tax rate of 25% (with tax paid in the year, for simplicity). The business buys equipment for 30, repays 10 of the loan and pays a dividend of 15. At year end, receivables are 60, stock 48 and payables 36.

The P&L: revenue 500, minus cost of sales 300, overheads 120 and depreciation 20, gives operating profit of 60. After interest of 5, profit before tax is 55. Tax at 25% is 13.75, leaving net profit of 41.25.

It balances. Notice the story it tells: the business made a profit of 41.25 but its cash fell by 5.75, because it invested in equipment, repaid debt, paid a dividend and tied up more money in customers and stock. That gap between profit and cash is exactly what a three-statement model is built to show.

Building it in a spreadsheet

1. Set up three areas or tabs: inputs, calculations and outputs. Keep every assumption (growth rates, margins, debtor days, tax rate) in the inputs area, in one colour, and never type numbers into formulas.
2. Enter historical figures for at least one year so the opening balance sheet is real.
3. Forecast the P&L down to operating profit from your revenue and cost drivers.
4. Build a fixed asset schedule: opening balance, plus capital spending, minus depreciation, equals closing balance.
5. Build a debt schedule: opening balance, plus new borrowing, minus repayments, with interest calculated on the balance.
6. Forecast working capital from days assumptions, for example receivables equal revenue multiplied by debtor days, divided by 365.
7. Complete the P&L with depreciation, interest and tax.
8. Build the cash flow statement from the P&L and the balance sheet changes, and link closing cash to the balance sheet.
9. Add a check row: total assets minus total liabilities and equity, which should be zero in every period.

Common mistakes

• Hard-coding the cash figure on the balance sheet so it looks balanced. Cash must come from the cash flow statement.
• Getting signs wrong on working capital. An increase in an asset uses cash. An increase in a liability provides it.
• Forgetting that dividends and loan repayments are not P&L items.
• Forecasting revenue growth without the extra stock, receivables and equipment that growth needs. That makes the cash look better than it will be.
• Mixing inputs and formulas, so nobody can tell which numbers are assumptions.
• Building a single answer with no scenarios. Add a downside case at least.

When to build one, and when not to

A three-statement model earns its keep when you are raising money, borrowing, planning significant investment or growth, or valuing a business. Lenders and investors expect one because it shows that your profit plan is consistent with your cash and your balance sheet.

For a very small, stable business, a profit budget plus a simple cash forecast may be enough. And for week-to-week cash management, a direct cash forecast built from expected receipts and payments is usually more accurate than a model driven from the P&L. Use the three-statement model for the year-by-year picture and the direct forecast for the next few weeks.