It's all about cash...
Data on debtors and outlays from the 2012 Cost of Time Survey illustrate the scope for law firms to improve their cash position in the face of fallling profits
The 2012 Cost of Time Survey was once again based on a good cross-section of solicitors’ firms in Scotland. With 244 participants, it remains the largest annual survey undertaken by any law society in the UK and is, as far as we are aware, the largest undertaken by any bar association in Europe.
The results indicate that life continues to be tough for most firms: median profits fell back this year to just £64,000 per equity partner, the same level as two years ago. The word “profit” can, of course, be misleading, particularly for non-lawyers, as it implies a surplus over and above the costs of running a business. For a firm of solicitors, its costs do not include any salary for the equity partners, and this surplus is their income. It represents the equivalent, for someone employed in a company, of a salary for doing the work, interest on capital invested, rent for offices (if owned by the partners) and then finally a “super profit” to compensate the partners for the risk of actually running the business. If a salary is charged for the equity partners, many firms are trading at a loss.
Profits are therefore poor. However, the key message from this year’s survey relates to cash, and the money “locked up” in debtors and outlays. Last year, there was a slight improvement, but this year, no doubt reflecting general pressure on both business and consumers, the cash position for many firms has worsened. The first problem has been an increase in the amount of debtors carried by each fee earner, as illustrated by chart 1.
The increases are not in themselves large; however, if you have a number of fee earners, the cumulative effect can be. For example, sole principals are having to fund more than twice the 2007 level, and 2-4 partner firms are 50% higher. Firms with 5-9, and 10+ partners have, by contrast, improved their position, but overall the position has worsened in the last 12 months.
The situation is even clearer when you look at the median “debtor days” for the different sizes of firm, as shown in chart 2.
“Debtor days” seeks to express a firm’s debtors in terms of the number of days fees are “locked up” in debtors. To take a simple example:
- Let’s assume a firm’s annual fees are £500,000 and its debtors at year end are £120,000 (£100,000 excluding VAT).
- Its average daily fees are £500,000/365 = £1,370.
- Its debtor days are debtors divided by average daily fees, or £100,000/£1,370 = 73 days.
This firm had five partners, so they are clearly not doing well on cash collection, and compare poorly to the median of 44 days for firms of their size.
In order to understand better a firm’s debtors, and the effectiveness of its cash collection, it is useful to compare within a firm and to track over time. Table 1 analyses the example firm between its different departments:
This very simple example hopefully illustrates the concept that looking at such figures on a departmental basis can be very useful. The overall figures can be distorted by the actual work undertaken because some areas, such as residential conveyancing and legal aid, are in effect accounted for on a cash basis. Analysing the information on a departmental basis starts to overcome this, and once you have the information, you can start to ask questions.
It is also very useful to track the figures over time, as you can tell whether they are improving or getting worse. There may, for example, be very good reasons why the family department is owed three months’ work, and commercial four months’, but anything that can be done to improve the position improves the firm’s cash flow. If commercial could be reduced to, say, 90 days, the bank balance would be improved by nearly £15,000. These figures can be usefully monitored on a quarterly basis.
The survey also indicated an increase in outlays per fee earner, as shown in chart 3.
The chart indicates an increase in the overall amount being funded from £2,000 to £2,500 in the last year, suggesting fee earners are having difficulty getting clients to fund outlays.
The overall impact of the reduced profits and greater difficulty getting paid is a worsening bank position, as indicated in chart 4.
Firms with 10+ partners, for example, have seen their median bank balance deteriorate from £219,000 last year to £57,000 this year. Those with 2-4 partners have seen a fall from £27,000 to £6,000, and 5-9 partner firms have also seen a major fall. So the priority has to be a healthy focus on cash:
- Be clear with the client at the outset what it is going to cost – remember that your credit control system starts with your initial engagement letter, and there is no point getting a client if payment is going to be a problem.
- Obtain credit ratings for commercial clients.
- If the cost of the matter does change, keep the client informed – not just of the costs so far, but your estimate of what is to come.
- Bill frequently, at least quarterly, and for some clients monthly. Clients prefer “little and often” and they are more likely to pay promptly when they still think you are great.
- Try always to obtain outlays up front.
- Make it easy for clients to pay by accepting credit or debit cards.
- Produce monthly aged debtors reports, and pursue old balances hard.
- Don’t let fee earners (especially partners) get in the way of the cashroom chasing a client for payment. Clients, especially commercial clients, will respect you more if you behave commercially.
- Do anything you can to avoid a bad debt. Any increase in bad debts comes straight off your bottom line.
So the key, at least for now, is cash – do everything you can to minimise the amounts clients owe, and to maintain a healthy cash flow.
Andrew Otterburn has advised about 250 firms on their management and profitability, and is currently working with firms facilitating partner retreats, advising on management, and generally on how profitability can be raised. Author of Profitability & Law Firm Management (Law Society of England & Wales, 2007), his second book, From Recession to Upturn – financial management and strategy for law firms, was published by the Law Society of Scotland in 2010. He is a founder member of the Law Consultancy Network, a network of independent law firm consultants.
Dr John Pollock, a consulting actuary, has been responsible for the administration and statistical aspects of the Cost of Time Survey since 2002. John is well known to personal injury, employment and family law solicitors in Scotland through his expert witness work at Pollock & Galbraith Consulting Actuaries.