What it means
The common thread is dependence. When two items are linked, you cannot change one without thinking about what happens to the other, and ignoring the connection leads to errors in forecasts, plans or deals.
In financial modelling, linkage is how the three main statements talk to each other. Net profit from the income statement flows into retained earnings on the balance sheet, depreciation affects both profit and asset values, and the change in cash on the balance sheet must match the cash flow statement.
A model that is properly linked updates every statement automatically when an assumption such as sales growth changes. In economics, linkage describes how industries rely on each other.
A backward linkage connects a business to its suppliers, so that a new car plant creates demand for steel, tyres and components. A forward linkage connects a business to the users of its output, as when a new oil refinery supports petrochemical producers.
In negotiation and policy, linkage means tying one issue to another so that progress on one depends on progress on the other. A supplier may link a price reduction to a larger volume commitment, and governments sometimes link trade concessions to other policy changes.
The approach can help parties reach agreement, though it can also stall talks if each side insists on the other moving first. Whichever meaning is in play, the practical advice is the same: map the connections before you change anything.
A simple diagram of what depends on what often reveals knock-on effects that would otherwise surface only after a decision is made. In a model, colour coding the linked cells and keeping the assumptions in one place makes the connections much easier to audit.
In practice
Real-world examples.
Example
An analyst builds a forecast model for a retailer. She links sales growth to inventory, receivables and cash so that raising sales by 10% automatically shows the extra working capital the business will need. The board can then see at once whether growth is affordable from internal cash.
Example
A regional government attracts a battery factory and then plans training colleges and logistics parks nearby. The factory has backward linkages to suppliers of metals and forward linkages to carmakers.
Example
A procurement manager offers a supplier a three-year contract in return for a 6% price reduction. The price cut is linked to the longer commitment, and neither side agrees without the other. The supplier gains certainty of volume, and the buyer gains a lower unit cost.
Formula
Calculation
Closing retained earnings = opening retained earnings + net profit - dividends paid.
Suppose a company starts the year with retained earnings of $400,000, earns a net profit of $150,000 and pays dividends of $50,000. Closing retained earnings = 400,000 + 150,000 - 50,000 = $500,000. This is a linkage because the income statement figure of $150,000 and the dividend decision both flow straight into the balance sheet. If profit is revised to $180,000, closing retained earnings becomes 400,000 + 180,000 - 50,000 = $530,000 without any other manual change.Case study
Seen in the real world.
Oakhill Furniture is an illustrative, fictional company whose finance team built a budget in separate spreadsheets for sales, production and cash. Each team typed its own numbers, and the pieces were only combined in the final week before the board meeting.
When the sales team raised its forecast by 20%, nobody updated the production schedule or the cash plan, and the board approved a budget that would have run out of cash in the fourth quarter. The error surfaced only because a junior analyst noticed that inventory purchases did not match the sales figures.
The company rebuilt the budget as one linked model, in which a change to sales flowed automatically into production, inventory and cash. In this illustrative case, the next forecast review took half the time and caught a funding gap early enough to arrange a credit line. The finance director also made one analyst responsible for checking that the balance sheet balanced after every change.
Watch out
Common mistakes.
- Typing numbers into a model instead of linking cells, so that a change in one place does not flow through and the statements stop agreeing.
- Ignoring indirect effects, such as the impact of a supplier price rise on working capital as well as on profit.
- Using linkage in negotiation as a threat, which can damage trust and leave both sides worse off.
Questions
People also ask.
What is the difference between backward and forward linkage?
Backward linkage connects a business to its suppliers, while forward linkage connects it to the buyers or users of what it produces.
How do I check that a model is properly linked?
Change a key assumption such as sales, and confirm that the balance sheet still balances and the cash flow agrees with the change in cash.
Is linkage always a good thing?
No, strong links can spread problems quickly, as when the failure of one supplier disrupts every business that relies on it.
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