Drawings and profitability

As all partners know, the key to success of a law firm is managing cash. We need profitability, but above all we need cash. Most partners recognise the importance of prompt billing and trying to get reasonably quick payment. However, one of the tricky areas can relate to drawings and ensuring that partner drawings do not exceed profits – and cash being generated.

In 2014 the Society launched a toolkit to help firms improve their financial stability, and at Journal, February 2014, 34 I described two ratios that banks use to assess a law firm’s financial position, looking at the relationship between a firm’s borrowings and capital. This article describes a third ratio that your bank is likely to calculate and that you should also understand – the “make and take” ratio, which compares drawings with profits.

How do you calculate this?

Simply take the profits available for the partners as shown in the accounts and compare this to total drawings in the accounts: monthly drawings plus payments of income tax.

The illustrations relate to a small firm and a larger firm with £10 million turnover. For each, profits are shown calculated on an accounts basis and also on a cash basis. On the accounts basis, the calculations for both firms appears to indicate all is well – drawings do not exceed the profits being generated.

This is a useful starting point, but “profit” is not the same as cash. Because a firm’s profits are affected by changes in debtors and work in progress, the profits shown in a firm’s accounts may be very different to the cash in the bank.

In the larger firm, the profits shown in the accounts are £3 million. However, part of these profits (£0.5 million) is due to an increase in work in progress. The “cash profit” actually available for the partners to draw is £2.5 million. Debtors have also increased by £0.5 million, so the actual cash generated in the year is just £2 million. The position of the two- partner firm is also bad – profits as shown in the accounts are £132,000; however, £50,000 of this relates to an increase in work in progress and may take months to be translated into cash in the bank. Fortunately there has been no change in opening and closing debtors.

To calculate the “cash” profit, take the profits figure as shown in the accounts and adjust it for any increase/decrease in work in progress. If debtors have changed significantly you should include that movement as well, as that also affects the cash available.

It is very easy for partners to misunderstand the actual cash available for drawings and inadvertently start overdrawing and increasing the firm’s borrowings. If possible, partners should try to keep their drawings within not just the profits as shown by the accounts, but the actual cash being generated by the business.

It can be hard to establish what this might be, but as the financial year progresses it might be possible to predict whether levels of work in progress and debtors are rising or falling and then take action to ensure problems do not arise.