Smooth Operator

04/01/2013
From: Law Practice Management and Technology Section, The Bottom Line - April 2013

The concept of benchmarking — setting up statistical guidelines to identify best management practices — can be a tremendous benefit to law firms. The appropriate financial benchmarks can identify operating deficiencies in the firm and show where you are currently relative to your goals. Financial benchmarking helps law firms improve business effectiveness by tracking profitability, cash flow and collections. Lawyers who understand financial benchmarking can better assess the value they provide to clients, and better reflect it in their bills.

Performance Factors

Benchmarking focuses on profitability, reflecting the value creation dynamic of any business enterprise: Profits equal Revenues minus Expenses, in other words, P = R — E. Although this is a simple equation, there are a number of performance factors that underlie it to 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.

Billing rates and realization percentage are key markers of any firm’s financial strength. Look at your standard rates and any alternatives you use. Are you able to bill premium rates? Must you frequently offer discounts? How do your rates compare to those of your competitors? The answers to such benchmarking can be revealing.

Realization Rates

Billing rates are important, but don’t over—emphasize them. The key to any law firm’s performance is realizing the money you collect from the hours you bill. This realization is sometimes discussed in two levels: Billed to billable ratio (the percent of billable or booked hours billed), and collected to billed ration (percent of billed work collected. The goal is to have a high collected to billable ratio. An overall realization of less than 85% is a recipe for trouble, because it means the firm has to treat 85% of its billings as 100% of its revenue.

Revenue of course can be variable, especially for a small firm. A good method for estimating it is the accounting measure of turnover ratio. The turnover ratio tells a lawyer to expect payment for billings X number of days after a client receives a statement. The average for law firms can run between 120 and 150 days — as much as five months. 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. Collecting the money that clients owe you should be your first financial priority.

Cash Flow

Too often lawyers realize that they are in financial trouble only after the money ceases to come in the door. However, cash flow cessation is usually the last symptom of a downward spiral that started long before. That is why the development of a cash flow statement is essential. 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.

This process directly relates back to collections. Keep your accounts receivable listing always current to make sure that your clients are paying you in accordance with their agreement. It is vitally important that you move quickly to collect any overdue accounts. Typically, a bill that is 60 days past due can still be collected about 90% of the time. However, that drops to a 67% likelihood of collection after six months, and a 45% likelihood after one year. You truly have a good relationship with your client only when the client's account receivable is up to date, and continuing to work for such a client without payment means you are simply providing an interest—free loan to them.

Profit and Loss

If you’ve properly managed cash flow and collections, you will have a profit to tally up. 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. Financial analysis for the small firm is a process of identifying and deducting the expenses of the practice (staff, rent, taxes, professional services) from monthly cash received, and drawing compensation from the balance.

Improved Practice

This kind of financial benchmarking and analysis need not involve mastering management jargon or looking at things though the eyes of an M.B.A. Today’s financial information systems and software can produce extremely detailed assessments of performance to benchmarks, ones that can be tailored to provide information that the typical attorney can assimilate intelligently. The most practical approach to understanding your firm’s finances is to use software that makes the assessment process virtually automatic, and points out major variances for attention. Such tools can replace static financial information with a continuous flow of automatically collected current operating metrics.

Even so, it is a mistake to rely on software alone. Lawyers should possess the business competency to understand, and even calculate, the traditional key measures of law firm performance: realization, utilization, leverage and expenses. That includes the firm’s collection rate — and their own personal one. It takes such insight for benchmarking to be meaningful, no matter how sophisticated is the financial software that the firm uses.

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