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July/August 2006 Issue | Volume 32 Number 5 | Page 53
Business

Profitability

By David Bilinsky and Laura Calloway

Since launching this column, we've heaped on the information to help you explore different ways of looking at profitability in your firm. But profitability is such an important and often complicated subject that, before we take the class to the next level, we have some recap homework for you.

While we're in between school years, we want to return here to basics to refresh everyone on the reports you should be generating from your accounting system. In particular, we'll highlight some of the differences between cash-basis and accrual-basis accounting, with an eye toward providing you with deeper insight into the operation of your practice. As we go forward with new material, you can keep these pages as a ready-made reference in your studies, helping you place more green in your jeans, cash in your khakis, or loot in your suit at the end of the day.

 

Financial Reports for Smart Law Firms

Balance Sheet. This document, typically prepared once annually, shows a snapshot of the assets, liabilities and ownership interest in your firm as of the date the document is created. For internal purposes, it is most often used to determine the relationship between assets and liabilities. However, the balance sheet also reveals the extent to which the firm owners have their own money invested in the firm. That factor will have a lot to do with the firm's ability to borrow money as needed to sustain operations.

Income Statement. This is a measure of the revenues—or top-line metric —generated by the practice over a certain time period (typically monthly, quarterly or annually) as offset by the expenses incurred over the same time period. While the income statement can show the profitability of a practice over the period it covers, it won't present a true picture if the revenue isn't received in the same period during which the expenditures to generate that income were made.

For example, the monthly income statement of a firm handling contingency fee work may show completely different results depending on whether the income statement covers the month before a big contingency fee award (where you've incurred high expenses but little revenue) or the month after the award (when you've received high revenues but incurred few expenses). Accrual-basis accounting "matches" income and expenses to create a more accurate picture of profitability.

Cash Flow Statement. This statement takes your beginning cash balance for the period—which is typically a month—and adds in all revenues received, deducts all expenses paid, and arrives at the closing cash balance for the month. For those using an accrual accounting system (as opposed to a cash-based system), this is also known as the Source and Application of Funds Statement and is a necessity to bring everything back to "cash." The reason is that the accrual system recognizes revenues when the invoice is sent (not when it's paid) and it spreads out certain expenses (called depreciation) over the lifetime of the asset purchased, even though the expense was paid in full during one accounting period.

The accrual system can be very useful for looking at your practice over a long time period, but statements of cash flow are a necessity to keep a handle on that all-important asset—namely, cash.

Budget. The budget is an estimate of the sums you'll spend during a given period, and what you'll spend them on, along with the revenues you'll receive and how you expect to generate those revenues. There are two principle reasons for preparing a budget. The first is to know what to expect, financially speaking, for a certain time period (typically a year). The second is to compare your forecast numbers against your actuals (typically monthly and year-to-date), to determine if you are managing your practice within your expectations.

Your income statement and budget comparisons will often be your first indications of future trouble and should be looked at monthly, if not more often. Your personnel costs (including your own draws), rent and technology will generally account for approximately 85 percent of the budget. There is little that you can cut if times turn downward, so monitoring your budget is especially important as funds grow scarce.

Write-up, Write-down Report. This shows the variance between your actual fees billed on each matter over a certain time period measured against a standard measure—being your standard hourly rate times your actual hours logged on each matter. This comparison gives an indication of which matters or clients result in high write-ups or high write-downs. The typical benchmark is that an hourly rate-biller should have, on average, a 5 percent write-down rate, and a contingency fee-biller should have, on average, a 150 percent write-up rate. If you are outside that range, this report will draw it to your attention and allow you to take corrective action, typically by tighter client or file acceptance policies and retainer evergreen requirements.

Client Activity Reports. There are any number of reports that can be run for each client. The typical reports are:

  • Fees billed
  • Fees collected
  • Accounts receivable
  • Outstanding disbursements
  • Trust balances
  • WIP
  • EHR

Fees billed is simply a volume indicator—allowing you to rank clients based on their ability to generate high fees to low fees.

Fees Collected. If you aggregate legal fees by client, again rank-ordered from largest to smallest, you can determine which clients contribute large amounts toward your total revenues.

If you divide each of these client totals by your total annual revenue, you can spot whether you are in a position where a few clients can make—or break—your practice.

Accounts Receivable. By date-ageing your receivables (current, over 30, over 60 and over 90 days) and then ordering them from highest to lowest in each date range, you can see who is costing you money (since you are, in effect, financing unpaid fees). There is typically a 105-day delay, on average, between rendering an invoice and receiving payment. Your accounts payable are generally due in 30 days or less. Accordingly, since that is about three "paying" periods from an A/P standpoint, monitoring your A/R becomes an exercise in cash management—and in staying afloat!

Outstanding Disbursements. Just as with long-unpaid accounts receivable, clients who generate large disbursements use a disproportionate amount of the firm's capital, particularly if the firm carries the disbursements for any period of time. By rank-ordering outstanding disbursements by client from largest to smallest and dividing your total outstanding disbursements by each client-owed amount times 100, you learn the percentage that each client bears of outstanding disbursements. You can now see which clients are using a large proportion of your capital devoted to expense advances and, thus, answer the question of whether these clients are worth the costs of carrying them.

Trust Balances. This isn't a profitability measure as much as a way to determine which clients may soon be moving from the black into the red outstanding disbursements column as their own funds on deposit are depleted. Make sure trust accounts are replenished regularly to avoid your having to carry the financing costs of needed client disbursements.

WIP. Your work-in-progress is your inventory. But the problem with inventory is it doesn't produce income sitting on the shelf. A useful metric is the number of days that WIP sits in inventory before it is billed. Create a report that lists WIP per file along with the days it has been in inventory. WIP should turn over every 60 to 70 days. If you have large amounts that are approaching 60 days (or longer), it may be time to consider billing them and converting them to accounts receivable.

EHR. Your effective hourly rate results from dividing fees collected per client by the hours logged for a matter. If you then sort your clients by high EHR to low, you'll know which are high-margin clients (those that make you the most money for the least effort) and which are low-margin ones.

EHR is a much better metric than simply looking at revenues. For example, assume you have two clients, each of whom you billed $10,000. The revenue resulting is the same. Now assume that for client A you logged 100 billable hours and for client B you logged 500 hours. Client A's EHR is $10,0004100 = $100/hour, while Client B's EHR is $10,0004500 = $20/hour. You don't know the absolute profitability of either client, but in relative terms, you can clearly see that client A is much more profitable than client B.

Projected Billings vs. Cash Flow. If you have large upcoming cash requirements (liability insurance premiums, bonuses, income tax), then to match cash inflows to outflows and avoid having to draw on your line of credit to meet those needs, you must bill an adequate amount well in advance of the cash requirement date to ensure that the funds are in hand.

Accordingly, a report comparing your projected billings to your cash flow allows you to anticipate a cash-positive or cash-negative situation and take remedial action if necessary.

Realization Rates. No one uniformly collects his or her stated hourly rate. The realization report allows you to more precisely determine your actual hourly rate earned by client or matter. To generate this report, divide fees actually received by actual hours logged on the file (not just hours ultimately billed to the client). This provides you with an accurate statement of the true hourly rate on this file. If you rank-order the results, you can see which clients or matters generated high realization rates, and which are duds.

Leakage Reports. These reports determine the lost income resulting from time leakage—everything from failure to record billable time, to writing off time at billing, to writing off at the time of collection (or, more accurately, non-collection). By comparing the difference between your billable fee "ceiling" (your standard hourly rate multiplied by your annual billable hours target) and your actual annual fee receipts, you can see the total amount of your billable time leakage. By determining the time written-off, you also can figure your "leak" volume—and take steps to stop up the leaks.

Exception Reports. You can immerse yourself in detailed reports, but it's not the most profitable use of your time. Instead, instruct your bookkeeper to produce reports that provide only the exceptions—for example, unpaid fees or disbursements over a certain dollar threshold and a certain date range. In this way, you separate the forest from the trees, focusing in on the information necessary for problem solving.

Profitability Reports. Every firm should go through the detailed process of determining exactly what it costs for each fee-biller to provide an hour of service. Unfortunately, this can be quite time-consuming. Rather than do without this information entirely, you can do a quick-and-dirty overhead calculation to determine your average hourly cost for providing services. If you are a solo, simply divide your total annual expenses by your annual billable hours expectation. This provides a ballpark cost per hour or standard cost to render services. If you are not collecting at least your billable hour total times your standard cost on a particular matter, you are losing money on that file.

An example will help. Assume you expect $100,000 in draws from your practice. You pay your secretary $45,000 in salary and benefits. All other overhead expenses total $25,000 for the year. Your total expenses are $100,000 + $45,000 + $25,000 = $170,000. Assume you bill 1,700 hours per year. Your "standard cost" of rendering services would be $170,000 ÷ 1,700 = $100/ hour. If you are not collecting at least $100 for each hour you put into a matter, that matter is costing you money.

If your firm is composed of multiple timekeepers, you need to determine each time-biller's overhead rate or decide to treat all fee-billers equally, at least in terms of standard overhead rates. However you decide to do this, having some idea of standard cost amounts will allow you to start to determine absolute profitability of clients, files, lawyers and practice groups. This is the first step toward moving from top-line metrics—simply looking at revenues—to looking at true profitability factors, such as hourly cost of services, EHR and realization rates. You can then start to look at factors such as client selection and retention, compensation, bonuses, capital contributions and other financial decisions based on hard financial data. Most importantly, you can start to maximize the dough in your Dockers by focusing on real financial data.

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