Those elusive profits

The 2014 Financial Benchmarking Survey, published this month by the Law Society of Scotland, indicates that overall profits have increased this year from £64,000 to £69,000 per equity partner. The results are still way below the levels achieved before 2008, but at least there has been an improvement. Curiously, the improvement has been driven by one size group – 2-4 partner firms – with all other size groups seeing a fall in profits: see chart 1.

Relatively high profits

Chart 2 summarises the range of profitability with, as always, a clear distinction between those above and below 10 partners. Among the former group, profits have always been higher; however, among smaller firms many are also achieving relatively high levels of profit. A quarter of sole principals, 2-4 and 5-9 partner firms were all earning profits per equity partner in excess of £90,000, with a quarter of 5-9 partner firms achieving profit greater than £125,000.

Undercapitalised?

“Profit” of course is not the same as cash in the bank, and getting paid promptly remains a huge issue for many firms. Firms are funded by a combination of bank borrowings and partner capital, and the third chart indicates that partner capital remains low for many firms. Having sufficient partner capital and not being over reliant on your bank is important, especially as banks’ willingness to lend to law firms may well change with the new banking rules. In particular, a firm’s client account will become far less attractive. Capital per partner – and this comprises any fixed capital, current accounts and also tax – among a quarter of sole principals and 2-4 partner firms was under £13,000: see chart 3.

More debtors, less cash

For many practices their level of funding is not helped by high debtor levels. Chart 4 illustrates debtor days. This seeks to express a firm’s debtors in terms of the number of days’ fees locked up in debtors. To take a simple example:

• Assume a firm’s annual fees are £500,000 and its debtors at the year end are £120,000 (£100,000 excluding VAT);
• Its average daily fees are £500,000/365 = £1,370;
• Its debtor days are £100,000/£1,370 = 73 days.

As indicated in the chart, a quarter of sole principal firms are owed more than two months’ fees, and a quarter of 2-4 partner firms one and a half months’ fees. The firms are likely to have to fund the same amounts again in unbilled work in progress.

Keys to cash management

Median debtor days increased slightly from 31 days in 2013 to 34 days in 2014. We have outlined some of the key pointers for cash management in the past, and they bear repetition:

• Be clear with your 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.
• 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.
• 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.

Last year the Society published support for firms on business sustainability that included checklists and ratios that the banks use, which you should also be aware of and understand.

These were described at Journal, February 2014, 34, and can be accessed at: www.lawscot.org.uk/members/member-services/business-sustainability