Three Statement Model

What is a Three Statement Model?

A three-statement model is nothing but the income statement – cash flow statement- the organization’s balance sheet. The model, by its very nature, is vast and holistic. A complete three statement model is prepared to its fullest extent only at the end of the accounting year. Thus, they account for and accommodate all the changes that have taken place in the year. No matter how huge or widespread the business of the organization. Every entity, without fail, must prepare a three-statement model at the end of each year.

This model boils down the vast operations and various functions of the entity to a matter of a few spreadsheets. Thus, this enables the management to obtain a bird’s eye view of the workings of their company at a quick glance. It informs the management of exactly how much they need to know- nothing less, nothing more. Thus, sparing the busy executives from losing precious time in going through the redundant nitty-gritty. Therefore, a three-statement model is a proactive strategic tool that streamlines the effort of management.

Additionally, the three statement model, namely income statement, cash flow statement & balance sheet, is what eventually forms a part of the business’s annual report. The emphasis on an efficient and dynamic model is therefore easily understood. It serves as a significant means of conveying the state of current operations and the road ahead to the external stakeholders.

Cash Flow Statement

A cash flow statement depicts the changes in the cash balance from the beginning of a period to its end. It clearly indicates the points of inflow and outflow of funds for the business.

The significance of a cash flow statement can be understood by the following points: –

  1. Efficient Management of Cash
  2. Future Forecasts based on Historical Trends
  3. Cash Planning & Budgeting for Capital Expenditure
  4. Indicative of current liquidity of business based on cash balances.

A Cash Flow statement is primarily divided into three segments

Cash Flow from Operating Activities

Cash flow from operating activities represents the cash generated through the principal profit-making business activities of the company. Therefore, such cash flows are a result of the primary transactions of the business necessary for the day to day activities. For example, cash receipts from the sale of goods, cash payment of taxes, cash payments for utilities such as electricity rent, etc.

It is important to note that the impact of non-cash items forming a part of the income statement must be eliminated. Failing this, the reconciliation of cash balances shall not be accurate. Examples of such items include profit on the sale of machinery (capital profit, not revenue).

Cash Flow from Investing Activities

Represents the cash flows arising from the disposal or acquisition of long-term assets. Items not falling under cash and equivalents are included here. A separate disclosure under this head is necessary. It indicates the extent to which the company has taken steps to earn additional income from spare funds. Examples include cash for the purchase of land, dividends received on securities held, and proceeds from the sale of long (or short) term securities.

Cash Flow from Financing Activities

Represents the inflow and outflow of cash, resulting in a change in the size of the owner’s equity or borrowing. This statement gives a clear idea of the financial health of the firm. This subset of the cash flow statement is of utmost importance to external stakeholders and analysts since they obtain information regarding the debt taken on by the firm and its consequent effective utilization.

Format of a Cash Flow Statement

CASH FLOW STATEMENTCurrency
Cash Flow from Operating Activities 
Receipts from customers 
Cash paid to suppliers and employees 
Cash generated from operations 
Income tax paid 
Cash flow before extraordinary items 
Net cash from Operating Activities(a)
Cash Flows from Investing Activities  
Net Proceeds / (purchase) of fixed assets Purchase of investments 
Interest received 
Dividend received 
Net cash from Investing Activities(b)
Cash Flows from Financing Activities 
Proceeds from the issue of share capital 
Net Proceeds/ (Repayments) from long-term borrowings 
Interest paid 
Dividend paid 
Net cash from Financing Activities(c)
Net increase / (decrease) in Cash and Cash Equivalent(a+b+c)
  Cash and Cash Equivalents at the beginning of the period(X)
  Cash and Cash Equivalents at the end of the periodX+(a+b+c)

Difference of Classification IFRS Vs. US GAAP

Globalization and increasing cross-country trade are at an all-time rise. Therefore, there is a large emphasis on integrating and streamlining accounting and reporting practices worldwide. The goal is to enable comparison and understanding of all businesses irrespective of their place of operation. Some success has been achieved in this regard. However, there still do exist some disparities.

IFRS being a global standard, strives to be accommodating and lists multiple practices to offer flexibility. On the other hand, US GAAP is more stringent and prescriptive in its standards. In the United States, domestic public companies must mandatorily comply with US GAAP, while IFRS is optional.

Items treated differently under US GAAP & IFRS are highlighted here below:

TransactionIFRSU.S. GAAP
interest receivedoperating or investing activitiesoperating activities
interest paidoperating or financing activitiesoperating activities
dividends paidoperating or financing activitiesfinancing activities
taxes paidmainly operating activities, but a portion of tax expense can be allocated to investing or financing activities if it can be directly assignedoperating activities
Three Statement Model

Income Statement

Another aspect of the three statement model, the income statement, is of utmost importance. It is the single most statement underlining the bottom line and overall profitability of the company. Without a meticulously prepared income statement, the business takes a shot in the dark. No matter how much the business seems to boom. Unless all the numbers are down on paper, no results can be authentic.

Balance Sheet

The balance sheet is a statement of the assets and liabilities of the corporation. The income statement conveys the operational results and financial position over a period of time (flow concept). The balance sheet conveys the position of the business at a particular point in time (spot concept). A balance sheet depicts the company’s net worth and gives a division between its own equity and borrowed funds. Key indicators such as liquidity, solvency, and adequate turnover ratios are numbers that can only be picked up from a balance sheet.

Utility of Financial Statements

Stakeholder Confidence

Financial statements are the only means of communication between the management and the shareholders since the latter cannot participate in the company’s day-to-day management. Therefore, the management must present the financial statements to them from time to time. Annual reports and other company publications are the only tools that inform the shareholders of the effectiveness and efficiency of operations. They can, therefore, form an opinion on its profitability, future prospects, and whether or not to invest.

Check on controls

Properly drafted financial statements serve as a rectification and correction mechanism for the business. The management has a ready report of its operations, thus enabling it to spring into corrective action as soon as required.

Forecasting

Records of financial statements of the business of the previous years serve as a valuable data bank. Based on such historical information, the business can identify trends and strategies that work best for the company. It can thus extrapolate existing numbers to forecast future results and adopt patterns best suited to the company.

Statutory Requirements

All countries have mandatory regulations in place regarding the maintenance of books of accounts. They are statutorily required to be maintained and audited to comply with regulatory and taxation requirements. Moreover, it is essential to present financial statements to financial institutions and banks to obtain credit. Proper upkeep of books of accounts is, therefore, indispensable.

Income Statement & Balance Sheet Model / Format

Take a look at the following practical example to understand the financial statements.

The below-mentioned financial statements have been modeled from a trial balance with the aid of additional information.

The following is the Trial Balance of Omega Limited as on 31st December 2017.

Particulars Debit Particulars Credit
Land at cost 220 Equity Capital (Shares of ` 10 each) 300
Plant & Machinery at cost 770 10% Debentures 200
Trade Receivables 96 General Reserve 130
Inventories (31.3.X2) 86 Profit & Loss A/c 72
Bank 20 Securities Premium 40
Adjusted Purchases 320 Sales 700
Factory Expenses 60 Trade Payables 52
Administration Expenses 30 Provision for Depreciation 172
Selling Expenses 30 Suspense Account 4
Debenture Interest 20    
Interim Dividend Paid 18    
  1670   1670

Additional Information:

(i) The authorized share capital of the company is 40,000 shares of  $10 each.

(ii) The company, on the advice of an independent valuer, wish to revalue the land at

$360,000.

(iii) Declared final dividend @ 10%.

(iv) Suspense account of $4,000 represents cash received for the sale of some of the machinery on 1st January 2017. The cost of the machinery was $10,000, and the accumulated depreciation thereon being $8,000.

(v) Depreciation is to be provided on plant and machinery at 10% on cost.

Balance Sheet Model

The balance sheet for Omega Limited for the year ending 31st December 2017 and the income statement for the same period based on the given information can be drafted as follows.

  Particulars ($ in ‘000)
Equity and Liabilities
1. Shareholders’ funds  
  a. Share Capital 300
  b. Reserves and Surplus 500
2. Non-Current liabilities  
  a. Long-term Borrowings 200
3. Current liabilities  
  a. Trade Payables 52
  b. Other Current Liability 30
  Total 1082
Assets
1. Non-current assets  
  a. Fixed Assets  
        i) Tangible Assets 880
2. Current assets  
  a. Inventories 86
  b. Trade Receivables 96
  c. Cash and Bank Balances 20
  Total 1082

Income Statement Model

Particulars ($ in ‘000)
I. Revenue from Operations 700
II. Other Income 2
III. Total Revenue 702
IV. Expenses:  
Purchases 320
Finance Costs 20
Depreciation (10% of 7602) 76
Other expenses 120
Total Expenses 536
V. Profit (Loss) for the period (III-IV) 166

 



Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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