Why three statements matter
Most FP&A teams start with a P&L model. Revenue minus costs equals profit. It is intuitive and sufficient for basic budgeting. But a P&L alone cannot answer some of the most important questions a business faces:
- When will we run out of cash?
- How much capital do we need to fund this growth plan?
- What is the impact of extending payment terms to a large customer?
- How does accelerated depreciation affect our tax position?
These questions require an integrated three-statement model: income statement (P&L), balance sheet, and cash flow statement, all connected by a common set of assumptions.
The architecture
Income statement. This is your starting point. Build it from drivers (see our guide on driver-based planning). Revenue flows from volume and price assumptions. Costs flow from headcount, activity levels, and unit costs. The bottom line -- net profit -- feeds into retained earnings on the balance sheet.
Balance sheet. Assets, liabilities, and equity. The key working capital accounts -- trade debtors, trade creditors, inventory, prepayments, and accruals -- are driven by assumptions linked to the P&L. Trade debtors = revenue x debtor days / 365. Trade creditors = COGS x creditor days / 365.
Fixed assets are driven by the CapEx plan, less accumulated depreciation. Debt balances reflect the financing structure. Equity includes share capital plus accumulated retained earnings from the P&L.
Cash flow statement. Derived from the P&L and balance sheet movements -- never hard-coded. Operating cash flow starts with net profit, adds back non-cash charges (depreciation, amortisation), and adjusts for working capital movements. Investing cash flow reflects CapEx. Financing cash flow captures debt drawdowns, repayments, and equity issuance.
The closing cash balance on the cash flow statement must equal the cash line on the balance sheet. This is the integrity check that confirms the model is correctly integrated.
Building it step by step
Step 1: Historical data. Enter two to three years of historical financials for all three statements. This provides the baseline for assumption-setting and a check on model accuracy.
Step 2: P&L assumptions. Build the forecast P&L from drivers. Test that the historical relationships (gross margin, expense ratios) are preserved unless you have a specific reason to change them.
Step 3: Working capital assumptions. Set debtor days, creditor days, and inventory days based on historical patterns. These translate P&L items into balance sheet movements.
Step 4: CapEx and depreciation. Build a simple fixed asset schedule: opening balance + additions - disposals - depreciation = closing balance. Link additions to your CapEx plan.
Step 5: Debt schedule. Model existing debt facilities: opening balance, drawdowns, repayments, and interest. If you need new financing, add a facility with defined terms.
Step 6: Cash flow. Build the cash flow statement from the P&L and balance sheet movements. Verify that closing cash equals the balance sheet.
Step 7: Balance sheet balancing. The balance sheet must balance: assets = liabilities + equity. If it does not, trace the error through the cash flow statement. The most common causes are missing working capital adjustments or incorrect treatment of non-cash items.
Common pitfalls
Circular references. Interest expense depends on the debt balance, which depends on cash flow, which depends on interest expense. Break the circularity with an iterative calculation or by using the prior period's debt balance for interest calculations.
Missing the tax adjustment. Corporation tax is a P&L charge but often a different cash outflow (due to payment timing). Model both the tax charge and the tax payment separately.
Over-complicating working capital. For most businesses, debtor days and creditor days are sufficient. Do not model individual customer payment behaviour unless it is material.