Dynamic Budgeting: 10 Steps to Building a Three-Statement Model
Increase visibility, prioritize growth, improve cost savings, and maximize capital allocation opportunities with a Dynamic 2025 Budget Model as your corporate budgeting solution
A dynamic budget model is an essential tool for every Chief Financial Officer, providing an integrated view into a company’s expected financial performance and the implications of various conditions on growth, cash flow, credit metrics and liquidity. With a dynamic budget model, a CFO can efficiently align management, employees and the Board of Directors on strategic priorities, organic growth opportunities, M&A strategies, cost savings initiatives, capital allocation decisions and other important initiatives. By incorporating scenario analysis into a dynamic budget model, a CFO can prepare for a wide range of potential outcomes, enabling more agile leadership and faster corporate budgeting solutions.
If you want to learn how to build a dynamic 2025 budget model, or are curious about the benefits of implementing the best practices of a dynamic budgeting model into your existing process, read on!
Introduction
Before opening a spreadsheet, first consider how your dynamic 2025 budget model will be used and determine the priorities for your model. Is it going to be used to satisfy the annual corporate budgeting requirements of your Board and / or lenders? Will it be used as a tool for managing the performance of the company on an ongoing basis? Will it be used to make cost cutting or capital allocation decisions during the year? Is it being used to determine the amount of liquidity you will need or to measure debt capacity? Will it serve as the foundation for a long-range financial plan? The answers to these questions will determine the optimal structure for the model, the periods you should use for your model (monthly, quarterly, or annually), and the ideal duration for your model (1-year, 3-year, 5-year, etc.).
An effective dynamic 2025 budget model should include an integrated three-statement financial model, which links the income statement, balance sheet, and cash flow statement, enabling the CFO to assess the impact of various decisions on a company’s future financial and operating performance. It should also include a debt schedule and financial covenants, to ensure that cash flow, leverage, and liquidity are factored into decision making. Budget models with thousands of inputs are not necessarily going to be more accurate than budget models with fewer inputs. Complexity can render budget models ineffective as corporate budgeting solutions, so be thoughtful about your approach.
The dynamic 2025 budget model that we discuss in this primer is an annual budget with monthly inputs. It has separate drivers for the income statement, balance sheet and cash flow items and provides for up to three scenarios (base case, downside case and upside case). It includes a debt schedule, financial covenants and liquidity analysis. In addition it has inputs for actual financial performance during the course of the year and comparisons for actual vs prior year and vs budget. It also includes typical outputs used in Board presentations, lender presentations and for internal / management purposes.
10 Steps to Build A Dynamic Budget Model
1. Set Up the Income Statement
We recommend that you start by building the income statement, as it is the core driver of your dynamic budget model. You should begin by adding between one to three years of historic financials to help inform your future projections. If you are building a monthly model, you should add at least 12 months of actual historic financials, including growth rates and margins. The components of your income statement are:
Add revenue drivers unique to your business
Revenue: You should forecast revenue using your unique business drivers. These drivers could be simply period-over-period growth rates or assumptions for price and volume during the forecast period. If your company has businesses, divisions, products or geographic segments with different growth and / or margin characteristics, the budget model should forecast these segments separately. Be sure to give consideration to seasonality for monthly or quarterly financial forecasts.
Project COGS for various products or divisions
Cost of Goods Sold (COGS): Project the cost of goods sold based on historical margins or other relevant drivers. If you have modeled different businesses, divisions, products or geographic segments be sure to apply appropriate margin assumptions to each division to capture the impact of the changing business mix on your overall cost of goods sold, gross profit, and gross margins.
Estimate SG&A and other operating expenses
Operating Expenses: Estimate selling, general, & administrative (SG&A) and other operating expenses, which can be driven as a percentage of revenue, based on assumed growth rates, or can have a mix of fixed and variable assumptions. You do not need to model every category of operating expense separately. Consider grouping categories of expenses that will grow at similar rates to simplify your model. For example, if you have a category of expenses that are fixed and will grow at the level of inflation each year and another category of expenses that will rise with the level of revenue consider grouping each of the categories together for simplicity. Whatever approach you choose to take, it is important to be able to capture the impact of operating leverage on your business during your corporate budgeting process. If you have a high proportion of fixed costs in your business, as it grows, margins and cash flow will grow faster than revenue. f your business is experiencing challenges, operating leverage can exacerbate the impact on margins and cash flow and can require dramatic changes to avoid cash flow or liquidity challenges.
Depreciation: If your business is not very capital intensive you can model depreciation with a simple assumption for annual depreciation expense. If your business is more capital intensive or you are expecting changes in the level or nature of capital expenditures, you may want to build a depreciation schedule that calculates annual depreciation expense by segregating assets into different categories (e.g., buildings, equipment, vehicles, etc.) based on useful lives and depreciation methods. After segregating the assets, you would apply the appropriate depreciation method for each category (e.g. straight-line, where each asset is depreciated evenly over its useful life). Finally you would divide the asset’s cost by its useful life. You would repeat this same process for new capital expenditures.
Amortization: Amortization of goodwill and intangibles should be forecast based on your company’s individual circumstances based on an existing amortization schedule and expected amortization of any new goodwill or intangibles.
Interest Expense, Net: Link interest expense directly from the debt schedule (see below), which will capture the interest on both existing and any new debt. Include interest income derived from cash and cash equivalents. This can be netted against Interest Expense on the Income Statement, unless your credit agreement requires you to calculate covenants based on gross interest expense (before interest income). Practice Note: Building a fully linked three-statement model with a debt schedule will create circular references in MS Excel. You need to turn on Manual Calculation and Iterations to prevent any issues with your file.
Taxes: Apply a tax rate to pre-tax income to calculate taxes and net income. If you are modeling an S Corp or LLC you should make tax distribution assumptions in the cash flow statement (see below).
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Calculate EBIT, EBITDA, and Adjusted EBITDA (after consideration of one-time and non-recurring items) to get a clearer picture of operating performance, profitability, financial covenant performance and valuation implications of your dynamic 2025 budget model.
2. Build the Balance Sheet
The balance sheet provides a snapshot of assets, liabilities, and equity, with critical links to both the income statement and cash flow statement. When building your dynamic budget model, give consideration to seasonality for monthly or quarterly balance sheet forecasts. If you are building in scenarios, consider the impact of better or worse than expected financial performance on key balance sheet items (receivables, inventory, accounts payable, etc.).
Build in key balance sheet drivers
The corporate budgeting components of your balance sheet are:
Assets:
Cash and Cash Equivalents: Linked from the cash flow statement (see below).
Accounts Receivable: Typically driven off assumed account receivable days which represents the average period of time to collect receivables from customers. The basic formula is accounts receivable / revenue per day. For example, for a full year forecast, the calculation would be accounts receivable / (net revenue / 365). For a monthly forecast, the calculation would be accounts receivable / (net revenue / 30). Some practitioners prefer to use average accounts receivable to calculate accounts receivable days.
Inventory: Typically driven off assumed inventory days which represents the average days of inventory based on current performance. The basic formula is inventory / cost of goods sold per day. For example, for a full year forecast, the calculation would be inventory / (cost of goods sold / 365). For a monthly forecast, the calculation would be inventory / (cost of goods sold / 30). Some practitioners will use average inventory balances to calculate inventory days or may use inventory turnover instead. We recommend using inventory days because it allows for easier measurement of cash conversion cycle, which is an important measure of cash flow efficiency.
Other Current or Long-Term Assets: Other current or long-term assets can be modeled based on a percent of net revenue or a percent of operating expenses.
Property, Plant, and Equipment (PP&E): Calculated as the prior period’s PP&E balance plus capital expenditures minus depreciation for the period.
Liabilities:
Accounts Payable: Typically driven off assumed payable days, which represents the average days it takes for your company to pay its vendors. The basic formula is accounts payable / cost of goods sold per day. For example, for a full year forecast, the calculation would be accounts payable / (cost of goods sold / 365). For a monthly forecast, the calculation would be inventory / (cost of goods sold / 30). Some practitioners will use average accounts payable balances to calculate accounts payable days.
Accrued Interest: Accrued interest is the difference between accounting accruals for interest expense and the cash payments made to your lenders. To model this accurately, you should calculate accrued interest for each debt instrument in the debt schedule (see description below). For company’s with minimal debt, it may not be necessary to model accrued interest separately.
Accrued Taxes: Accrued taxes are the difference between accounting accruals for taxes and actual payments of taxes.
Other Accrued Expenses: Other accrued expenses include other items like accrued bonuses and are often projected as a percentage of revenue or operating expenses. You should give consideration to seasonality for monthly or quarterly financial forecasts.
Other Current or Long-Term Liabilities: Other current or long-term liabilities can be modeled based on a percent of net revenue or a percent of operating expenses.
Debt: Linked directly from the debt schedule (see below).
Equity:
Shareholders’ Equity: Calculated as prior period shareholders’ equity plus net income from the income statement, minus dividends or other distributions (e.g. tax distributions in the case of S corps), plus new issuances of equity, minus redemptions. Some practitioners will break out the different components of shareholders’ equity, but in our experience this is an area where you can simplify the model without impacting the utility.
3. Set Up the Cash Flow Statement
To build your cash flow statement create three sections: operating activities, investing activities, and financing activities and link items from the income statement and balance sheet.
Operating Activities: Begin with net income, add back non-cash expenses (like depreciation and amortization), and adjust for changes in working capital items, such as accounts receivable, inventory, and accounts payable. The categories should match the balance sheet exactly to avoid any issues later. Be careful to record the signs correctly: increases in assets are reductions in cash while increases in liabilities are increases in cash.
Investing Activities: Include capital expenditures, which can be projected as fixed inputs if there is a detailed capital investment plan, or as a percentage of revenue or using historical growth rates. If you are developing different scenarios, consider the impact of financial performance that is better or worse than expected on capital expenditure assumptions. If your business is capital intensive consider building a depreciation schedule that allows you to allocate capital among asset categories with different useful life and depreciation methodologies. Once you are finished, link all capital expenditures to the PP&E line in the balance sheet. Be sure to check signs.
Financing Activities: Capture debt repayments and any new borrowings directly from the debt schedule. Include any projected dividends or issuances / redemptions of equity here as well. Be sure to check mathematical signs (positive/negative).
When you sum the cash flow from operating, investing and financing activities, the result is the net change in cash, which is added to the previous period’s ending cash balance to get the ending cash balance for the current period. This ending cash balance should be linked to cash and cash equivalents on the balance sheet.
Most of the cash flow statement items are linked from the balance sheet or income statement, but we recommend building a cash flow drivers section in your model with inputs for capital expenditures, equity issuance, equity redemptions, dividends, and other distributions (inc. tax distributions for S corps or LLCs). We also recommend considering how better or worse than expected financial performance could impact these key drivers.
Build your cash flow statement
4. Build the Debt Schedule
A debt schedule shows how a company’s debt balance changes over time, including how cash is used to repay indebtedness, and calculates interest expense, which is linked to the income statement. We suggest modeling each debt instrument separately to capture the change in interest rates and overall interest expense based on the change in mix. For example, with a revolving credit facility you need to capture the total facility size and the undrawn amount in each period to calculate the fee on the undrawn amount. For each debt instrument calculate:
Beginning Balance: Start with the current debt balance for each debt instrument.
Debt Additions / Draw: Project any new incremental debt or draws on the revolving credit facility. These can be inputs directly into the model or can be triggered by cash needs of the business, for example if cash and cash equivalents at the end of a period drops below a minimum threshold amount. Note: This will create circular references so you need to turn on manual calculations and iterations.
Debt Paydowns: Model any scheduled repayments (amortization or maturities) and build in triggers for optional repayments and / or cash sweeps. Some credit facilities will have a mandatory debt paydown based on a formula for excess cash flow. Be certain to model these into your budget for planning purposes.
Ending Balance: Calculate the ending debt balance as the beginning balance plus new additions / draws, minus paydowns.
Interest Expense Calculation: Apply an interest rate to the average debt balance for the period (often calculated as the beginning balance plus ending balance, divided by two). If your debt has a variable rate of interest you may want to model fluctuations in the interest rate as part of the sensitivity analysis. Many practitioners will model future interest expense based on the current forward curve for the benchmark (e.g. SOFR). Practice note: Some debt instruments have pricing based on a leverage grid. If that is the case, consider adding the pricing grid, particularly if your business and financial performance are sensitive to increases in the interest rate.
Accrued Interest Calculation: Accrued interest is the difference between accounting accruals for interest expense and the cash payments made to your lenders. The timing of interest payments (monthly, quarterly, semi-annually) and the periods used for modeling will determine the amount of accrued interest for each instrument. For example, if your company makes interest payments in January, April, July, and October at the end of December you would have two months of accrued interest.
Calculate interest income on your cash balance
Interest Income Calculation: Calculate interest income based on the average beginning and ending cash balance for a period multiplied by the interest earned over the period. For the current interest income assumption select a rate based on the interest you are earning on cash today. If you maintain significant cash balances, consider projecting fluctuations in the interest rate over time.
Link the debt balance to the balance sheet and link the interest expense and any interest income directly to the income statement.
Note on Pay-in-Kind (PIK) Interest: For instruments with pay-in-kind interest you will need to allow for increases in the principal amount of the debt instrument. Some debt instruments will have a portion of cash interest and a portion of PIK interest, all PIK interest, or an option for the company to elect PIK interest under certain circumstances. You should review the terms of your debt instrument to determine the best way to model PIK interest for your company.
5. Covenant Schedule
Model your financial covenants to ensure compliance
Build a schedule of financial covenants from your credit agreement(s) or indentures. The financial covenants should be calculated in accordance with the definitions in the credit documentation to avoid any potential issues, this includes permitted add-backs and add-back caps. Also incorporate the actual covenants and indicate whether the company is expected to pass or fail the required covenant thresholds. If your company is expecting to fail a covenant consider re-evaluating the business plan, refinancing, and / or negotiating with your lenders for additional covenant flexibility.
6. Scenario Analysis
Scenario analysis helps assess performance under a variety of economic conditions
An effective dynamic budget model should enable evaluation of different scenarios. As CFO, you need to be prepared for a range of market conditions and financial outcomes. A dynamic budget model should provide visibility into growth, margins, working capital, capital expenditures, cash flow, liquidity and covenants under a range of potential scenarios.
7. Check the Links Between the Financial Statements
With all schedules and statements in place, ensure all the statements have been linked properly:
Income Statement to Balance Sheet: Make sure that net income is linked to shareholders’ equity, depreciation expense is linked to property, plant & equipment (PP&E), and amortization expense is linked to goodwill and intangibles.
Cash Flow Statement to Balance Sheet: Ensure that the ending cash balance from the cash flow statement flows into the cash line on the balance sheet. Link capital expenditures to PP&E.
Balance Sheet to Cash Flow Statement: Make sure all assets and liabilities other than cash, PP&E and debt are linked to the cash flow statement either in cash flow from operating activities or investing activities.
Debt Schedule to Balance Sheet: Ensure that the ending debt balances and accrued interest balances are reflected in the balance sheet’s liabilities section.
Debt Schedule to Income Statement: Ensure that interest expense and interest income are linked to the income statement either in an interest expense, net line item or separately.
Cash Flow Drivers to Cash Flow Statement: Ensure that capital expenditures is linked to the investing activities section of the cash flow statement and that equity issuance, equity redemptions, dividends, and other distributions (inc. tax distributions for S corps or LLCs) are incorporated into the financing activities section of the cash flow statement.
By linking all three statements, changes in assumptions (such as revenue growth or interest rates) will flow through the model, updating each financial statement and giving you a dynamic view of the company’s financial position. Linking the financial statements will create circular references. You need to allow manual calculations and iterations to avoid any errors in your model.
8. Incorporate Actual Financials
Build a placeholder for actual financials for the income statement, balance sheet and selected cash flow items. As the year progresses, incorporate actual performance and compare it to prior year performance and to the budget performance. If actual financial performance differs materially from the budget consider reforecasting the rest of the year to refresh your understanding of the range of potential financial and operating scenarios.
Incorporate actual performance to align with your budget projections
9. Develop Outputs
In order to get the most out of your dynamic 2025 budget model, build specific outputs for your different stakeholders (management, the Board of Directors, investors, and lenders). Include outputs for the final budget, rolling budgets (updated for actual performance), and actual financial performance comparisons versus prior year and versus the budget. Below are examples of common outputs:
Typical Budget Output
Typical Rolling Budget Output
Typical Comparison vs Last Year and vs Budget Output
10. Validate and Test your 2025 Budget Model
A final step in any corporate budgeting solution is to validate that the model works as expected. Run tests by adjusting key assumptions, such as revenue growth, margins, balance sheet assumptions or capital expenditures, and verify that changes are reflected consistently across all three statements. Common checks include:
Balance Sheet Check: Verify that total assets equal total liabilities plus shareholders’ equity.
Scenario Checker: Verify that your scenarios are running properly. Are scenarios with better or worse financial projections yielding better or worse financial outcomes? If not, there could be an issue with your model mechanics.
Liquidity Check: Ensure that your maximum revolver draw does not exceed the total size of your facility. Ensure that you maintain a minimum amount of cash required to operate your business. And ensure that the amount of cash plus undrawn revolver does not drop below a minimum pre-determined amount.
Covenant Check: Ensure that you are compliant with all your financial covenants. If your company is expecting to fail a covenant, consider re-evaluating the business plan to cut costs or reduce capital investment, refinancing your existing debt and / or beginning negotiations with your lenders to receive additional covenant flexibility.
Sanity Check: Do the outputs make sense given historic trends and your expectations for the future? Are there major changes in growth rates, margins, cash flow characteristics, etc.? If so there may be an issue with your model assumptions or the model mechanics.
Conclusion
Your dynamic budget model can be a powerful tool for assessing your company’s financial health and future outlook. It can provide you with an integrated view into the impact of various assumptions on growth, cash flow, credit metrics and liquidity. Insights that can prepare you for a wide range of potential outcomes, enabling more agile leadership and faster decision making. Leverage these insights to align management, employees and the Board of Directors on strategic priorities, organic growth opportunities, M&A strategies, cost savings initiatives, capital allocation decisions and other important initiatives.
Unleash your potential to grow faster and create more value.
For help building your next dynamic model, contact Keene Advisors. Our team has built hundreds of financial models for clients across a range of industries. If you prefer to build the model on your own, save time by starting from a proven model template developed by our team.