I wrote this article for the legal magazine Without Prejudice and it was published in their September 2015 issue.
In recent years we’ve seen many articles with themes about ‘Why is the demand for legal services shifting?’ (legalexecutiveinstitute.com), ‘Law firm clients today are in the driver’s seat – asking law firms to provide more value at a reduced cost’ (businessoflawblog.com), and ‘Solving the Profitability Problem’ (legalexecutiveinstitute.com) and the key messages are that there is a ‘buyer’s market in legal industry’ and ‘law firms are shrinking’.
Law practices have experienced this in declining profits, a decline in billing realisation and a drop in collections, despite increases in standard rates. This trend is confirmed with Peer Monitor data reporting collection realisation at the end of 2015 at a low 83.8%.
The Legal executive institute attributes the reason to the change in the legal landscape to a change in clients’ buying habits. Clients are shifting to in-house council, alternative service providers, lower-cost firms and specialised firms. Alternative service providers entering the market are for example major accounting firms (PricewaterhouseCoopers, Ernst & Young, Deloitte, KPMG), LPOs (Legal process outsourcing), Dispute resolution systems and Document creation systems.
Continuously reducing fees to retain clients is not a solution to retaining clients as it is not sustainable. There are however strategies to survive in the evolving legal market such as partnering with alternative service providers, focussing on value-adding client metrics and the implementation of project management.
Each and every strategy requires financial practice management to move up a few notches. More sophisticated financial management enables the implementation of new strategies, the managing of more demanding clients (more value for less) through project management and improve monitoring and managing of the day to day operations in a more volatile era.
The two main areas of focus in financial management are margins and cash flow – margins to manage profitability and cash flow to run operations.
The ultimate aim of a law practice is profitability – the value generated for the stakeholders (partners). Profitability is the net result of fees, less costs to provide the service and overheads. Managing your margins entails more than deducting your overall costs from your fees and see what’s left over. Understanding your margins at a granular level to enable informed decisions is what matters. What returns do you make, on which clients, in what practice areas, who are the fee earners, which industries? Measuring and comparing margins between clients prompt investigation that can lead to strategic decisions regarding the future of certain clients or services. The same applies for knowing and understanding the margins of offices, practice areas and fee earners. Lower margins do not necessarily equate to bad business, however being able to understand and interpret it allows you to make informed decisions and not be taken by surprise. Equally, unusually high margins could be an indicator of risk that later impacts on your cash flow position.
Project management is required for the management of alternative fee arrangements to ensure that the projects are profitable. In a fixed fee arrangement, the price is fixed and costs have to be managed within the agreed price to result in a profitable matter. Tracking of cost against progress has to be done from the start of the project and maintained throughout. As soon as cost is higher than expected the project should be reviewed and alternative strategies considered to make it profitable. There is little to be done with major cost overruns at the end of a fixed fee arrangement.
Due to fixed salary scales or historical increases of both salaries and charge-out rates, the fees generated by fee earners over time could become misaligned with their earnings. Regular review and analysis can identify these and allow for refinement to protect the practice’s profit. Sometimes there is intentional misalignment of fees and earnings. An example of this might be a fee earner working on an internal project.
The billable hour is still the main driver of direct cost and to date also the main driver of billing in many law practices. There are schools of thought that time recording will phase out with conversion to alternative fee arrangements and off-shoring. Though time might no longer be the basis for billing, the measure of effort (cost) to deliver a service will still require the tracking of time as time is the main cost driver.
Time is the trading stock of a law practice and every hour counts and therefore disciplines to ensure regular time recording improves the bottom line. The sooner time is recorded the higher the level of accuracy and completeness. Time recording is also a useful tool in identifying potential issues and opportunities. For example, the amount of time taken to perform certain assignments compared to the fees invoiced can accurately point out areas for improvement (losses) or investment (profitable services).
The more time recorded from the hours worked, the higher the pool from which billing is generated. Only time that is billed and collected ends up in the bottom line. If a person worked for 100 hours, but only recorded 80% (80 hours) and then later bill only 90% (72 hours), there is a loss of 28 hours. If 90 hours are recorded and 90 % (81 hours) are billed, the unbilled hours reduce to 19. Improved time recording directly impacts the bottom line.
Most costs in law practices are fixed (salaries, rent) and not easily reduced. If the expected margins on fees are not achieved, the fixed cost might become a financial burden. Decisions on premises can have a huge impact on the ability to manage profitability and cash flows. During volatile times some flexibility in lease arrangements should be considered.
Cash flow management is the process of planning and predicting cash flow requirements to meet obligations on time and enable expansion. Cash flow constraints tap energy from a business as it not only creates a negative mood, but also distracts from winning business and servicing clients. Red flags go up when there are concerns over the ability to pay salaries or vendors or having a high accounts receivable book, but no money in the bank.
The cash flow position of a firm is a symptom of how well other areas in the firm are managed. Regular cash flow constraints can indicate poor discipline within billing, low quality customers, ineffective collections or unnecessary costs. To resolve the problem long-term the source of the problem has to be identified and not only solutions for the short term.
Cash flow volatility could also be attributable to the type and combination of types of fee arrangements. Billing done monthly for work to date provides some consistency in incoming funds. Alternative fee arrangements might be paid only at the end of the project, if no provision was made for interim payments. Funding for the resources on an alternative fee arrangement to the end of the project therefore has to be funded from other sources or projects. In an environment where a high percentage of fees are billed and paid monthly, historical trends and forecasts could be used as basis for cash management. Where the percentage of billings based on alternative fee arrangements which does now allow for an even inflow of funds is high, a more detailed cash forecasting model is required to management cash effectively. Such a model will cater for detail per substantial project.
Cash flow should become part of the fee discussions with clients with interim billing (at phase of the project) and retainers part of the negotiations. In turn clients might be looking for value in the form of for example progress reports before interim payments are made. There are no rules and the success of this is up to the fee earner to negotiate with a client.
Using vendor payments to manage cash flow has limited value in an environment where payments such as advocate fees are regulated and the majority of are payments are fixed e.g. salaries and building rental. That further emphasise the importance of project management in a law practice and a detailed business/budgeting model.
Project management to enable alternative fee arrangements, planning and cash flow management requires a different level of detail to differentiate law practices and to support practices through volatility. Each practice requires processes, systems and tools to manage through this new era and embrace the changes prepared.
The tangible value from enriched financial information materialises on taking action to make clients, practice areas or fee earners more profitable. Do zero-based budgeting annually and review the value of planned spending. Per Robert Kiyosaki’s rich dad: “The rich are rich because they have expenses that make them rich. The poor are poor because they have expenses that make them poor.”