In our previous column, we discussed some basic accounting terms and tools, including ledgers and the chart of accounts. We’re assuming that in your spare time you’ve done your homework by classifying all your items of income and expense according to that chart, as well as listing all your assets and liabilities. If so, you’re ready to start compiling the core financial statements that work together to give you an overview of what’s going on with your practice during a standard accounting period.
The income statement is pro-bably the easiest to explain, so let’s start with it.
Income Statements: Revenue and Expenses
An income statement covers financial activity that takes place over a designated period of time, such as a month. In its simplest form, the income statement can consist of only three lines: your total revenue for the stated period, less your total expenses for the period, equals the amount of net profit or net loss for the period. However, while this is useful information, it does not tell you much about where your money came from—or where it went.
Since information is the name of the game, an income statement usually consists of (1) a revenue section, which lists out and then totals all the general types of revenue your practice receives, and (2) an expense section, which breaks your expenses down into their basic types before summing them up and deducting them from total revenue.
For example, if you handle two or three different types of matters, such as criminal, social security and family law, you want to list your gross fees earned by each type of case. You also probably want to have a line on the statement for non-fee revenue, such as interest earned on the firm’s money market checking account or rental income received from the lawyer who subleases the unused office on the second floor. Expenses would normally be broken down into three or four major categories, too, such as salaries, occupancy expenses, library and research costs, and all other expenses.
By using a few major categories to aggregate all the income and expense items found in your chart of accounts, you are able to tell not only whether you made or lost money in a given period, but also to get a bird’s-eye view of where your revenue came from—and where it went.
Balance Sheets: What’s Owned and What’s Owed
Unlike the income statement, which shows performance over a given accounting period, a balance sheet is more like a snapshot of your financial status. It shows (1) what the firm owns, (2) what the firm owes and (3) the consequent value of all of the owners’ interests at a particular point in time.
The firm’s assets, which constitute the top half of the balance sheet, can generally be divided into the categories of tangibles (buildings, equipment, supplies) and intangibles (work in progress, accounts receivable). More commonly, though, they are classified as current assets, including cash and other items that can quickly be turned into cash (such as publicly traded stocks and accounts receivable), and longer-term assets, including personal property and equipment and other, related assets (such as promissory notes and rental or utility deposits that have an easily verifiable cash value but can’t be reclaimed and spent right now). The sum of all the asset categories determines your firm’s total assets.
The bottom half of the balance sheet consists of the firm’s liabilities followed by owners’ equity. Like assets, liabilities are most often divided up based on whether they are soon to be due and payable (short-term current liabilities, such as LexisNexis or Westlaw invoices, courier charges and the like) and long-term liabilities (such as mortgage debt and lease commitments). Just as all classes of assets are added together to arrive at total assets, all the firm’s liabilities are summed up to determine total liabilities.
The second aspect of the bottom half shows the value of the owners’ accumulated interest in the firm. Equity is created by the initial contribution of capital used to start the firm (whether in cash, equipment, furnishings or land and buildings), and it grows over time as the firm retains earnings or as other lawyers make capital contributions when they join the firm as partners or shareholders.
Assets always make up the top section of the balance sheet, and liabilities and owners’ equity always make up the bottom section. In fact, the two sections will always equal to the same sum. That’s why it’s called a “balance sheet”: Your total assets must always balance with your total liabilities and owners’ equity.
Equity Statements: The Changing Picture
The final financial statement that you should be generating regularly is a statement of change in owners’ equity. This statement reflects each shareholder’s relative ownership in the business, as well as how that ownership has changed during a stated period as a result of changes in the assets and debts, or profitability, of the firm. For example, when a firm’s debts go up without a related rise in the value of its assets (such as when a large malpractice judgment is awarded against the firm), the value of the owners’ equity must go down for the statement to continue to balance.
As you can probably see by now, the real value of your financial statements is not the numbers obtained for any individual period of time. Instead, it’s the way the statements enable you to compare the current period against your previous performance, spotting trends as you go.
Introduction to Financial Ratios
Standard financial statements provide a glimpse into your business performance. But to really make the rubber meet the road, you need to dig deeper and perform financial ratio analysis on your statements. So let’s now look at several standard ratios, together with ballparks indications of where your numbers should be for comparison purposes.
Liquidity ratios. These ratios measure the firm’s ability to pay its debts as they fall due.
• The current ratio is defined as: current assets/ current liabilities.
Look for your current ratio to be at least 1:1, although 2:1 is better, indicating that your current assets are more than sufficient to meet your current liabilities. The current ratio, however, says little about the timing of cash flows—such as when all your current liabilities are due immediately but cash isn’t expected for another three weeks.
• The quick ratio is the ratio between all assets that can be quickly converted into cash and current liabilities and is determined by: (cash + accounts receivable)/current liabilities.
Again, this ratio measures your ability to pay your bills, so look for it to be at least 1:1. Similar to the current ratio, the quick ratio can suffer from problems introduced by the timing of cash flows.
• The safety ratio is defined as: total debt/total equity.
It measures the capital provided by owners against the capital provided by lenders. The higher the safety ratio, the greater the risk of the business to a lender is. Your ratio should definitely not exceed 4:1. Many lenders have a limit of 2:1 for small business loans.
• The debt-coverage ratio is the result of: (net profit + non-cash expenses) /debt.
It measures your ability to take on additional debt and cover existing debt from cash flow. Lenders look at this ratio to determine if the business has adequate cash to repay debt.
Profitability ratios. Profitability ratios measure the firm’s success in generating income. They are affected by the firm’s ability to manage both assets and debt.
• The profit margin ratio, which looks at the dollars in income the firm generates from each dollar in revenues, is defined as: ( net income –: revenues) x 100.
A profit margin near 15 percent before taxes would be considered low; 20 to 30 percent is more typical. The higher your profit margin, the more profitable your practice is. It is also useful to examine this ratio over time—as in, is your profit margin increasing, decreasing or holding steady?
• The return on equity ratio, which reflects your rate of return on your investment in the business, is the result of: net income/equity.
This is one of the most important ratios that you can examine as an owner because it tells you whether you are being adequately compensated for the risks of being in business. If you could make more money by investing your capital in an alternate fashion—such as bonds, savings certificates or the stock market—then you should ask yourself why you’re not investing your time in managing your stock portfolio rather than practicing law.
Alternatively, if your law practice is providing a greater return than you could make elsewhere, your capital and time are being prudently invested in your practice.Next time we’ll delve into other financial ratios that are valuable in determining your firm’s profitability, your financial health, and whether you’re winning or losing the race.
David J. Bilinsky ( firstname.lastname@example.org) is the Practice Management Advisor and staff lawyer for the Law Society of British Columbia. Laura A. Calloway ( email@example.com) is Director of the Alabama State Bar’s Law Office Management Assistance Program.