September 2006

Every business, including The Business of Law®, is driven by a three-part cycle:

• Win the work (the marketing function)
• Do the work effectively and efficiently (the production function)
• Get paid (the collections function).

These three functions are distinct and separate. Most lawyers are familiar with and capable in marketing and production, but they fail to grasp the importance of collections. They feel a false sense of security as they pile up billable hours, but don't realize the danger in the uncollected cash that those hours represent. Bounced checks, failure to receive timely or full payment, client insolvency – these all can ultimately result in a lawyer's bankruptcy.

However, lawyers can control fee collection to a greater degree than they usually believe is possible. When an attorney agrees to perform services for a client, the lawyer and the client are entering into a two-way bargain. The attorney promises to perform legal services that meet or exceed the standard of the community and the expectations of the client, and the client agrees to pay for legal fees and disbursements in accord with the terms of the written fee agreement. Lawyers can take a variety of practical steps to ensure that clients keep their promise.

Elsewhere in this issue I've written on the financial importance of the collection function – turning billable work into cash receipts. Collections are the foundation of a firm's financial performance, but they also are inseparable from a number of other performance factors that determine a firm's profitability, including:

• Billing rates, whether hourly, blended (an average), fixed fee or other measure
• Utilization, the percentage of a workweek (usually expressed as an annual average) that a lawyer actually bills
• Realization, the amount of time actually billed and collected
• Leverage, defined as the ratio of non-partners (associates, paralegals, staff) to partners
• Expenses, related to both operations and compensation, as a percent of revenues.

It's one thing to identify these financial variables, and quite another for most firms to keep track of them. Today's financial information systems and software can and do produce far more information / data than an attorney can use or assimilate intelligently. I believe the only practical approach to understanding your firm's finances is to look at several broad measures.

First, and foremost, in my mind, is the development of a cash flow statement. Prepare a forward-looking budget of cash receipts and payments for the next 12 months. Keep that statement on a rolling 12-month cycle such that as you conclude the current month, you look at the 12th month and add it into your budget, adjusting all the other months if needed based on new information. As part of this process, relating back to collections, keep your accounts receivable listing always at your elbow to make sure that your clients are paying you in accordance with their agreement. If you do these two things, you will be far ahead of the financial curve compared to most firms.

When you get to the point of adding up the numbers, there are two basic methods for keeping track of law firm financial performance: accrual versus cash accounting. Accrual records reflect income irrespective of whether cash has been collected. In other words, accrual accounting reflects billings, work in progress (completed but not yet billed) and accounts receivable (work billed but not yet collected). Cash accounting, on the other hand, reflects only collections, never billings or work in progress. Almost all small law firms operate on a cash basis, accounting for cash as it comes in and goes out. Larger law firms maintain both cash and accrual records.

Income statements, also called profit and loss or P&L statements, tell how well a firm did financially in a given period of time. Income statements use the accrual method to tell how much revenue has been billed, how much expense has been accrued, and how much net income or profit resulted. Income or profit figures generally have little relevance to small law firms. Small professional service firms typically operate on a cash basis, with the lawyer's salary or draw coming from positive cash flow.

No matter what yardstick you use, financial performance for any size firm still depends on the collections function. Several years ago, when the 300-lawyer global law firm of Altheimer & Gray was forced to file for bankruptcy, a very important fact got little attention: the firm had $30 million in outstanding accounts receivable. Had Altheimer & Gray been more diligent and aggressive at collecting the money it was owed, it might have remained alive.

The importance of collections could not be more obvious, for the largest law firms and for solo practitioners alike. According to one survey, it takes between 120 and 150 days – as much as five months – for the average law firm to turn billable hours into cash. That means that a typical small firm should have funds sufficient to operate for at least six months without new billings coming in. But no firm should ever let things reach that point. In a book called " Collecting Your Fees," I wrote: "Law firms are not the victims of their delinquent clients. You and the firm itself cause your collection problems by not telling clients from the beginning what you expect from them, and continuing to follow through. Thus you and your firm are the only ones who can solve your collection problems." The solution is always in your hands. The best course for any lawyer is to make sure clients know they must pay their bills, on time.