Many times I have encountered the situation where a law firm has been forced out of business, even though it was expanding its client base and revenues were growing substantially. As we all know by now, some law firms have survived the recent recession, whereas others could not, for a number of reasons. In this column, I concentrate on the importance of efficiently managing cash flow for firms by reviewing some of the globally accepted best practices. Without understanding the importance of cash flow for endurance and longevity, firms dip into their line of credit more often than desired, just to cover necessary expenses.
PROFITABILITY VERSUS CASH FLOW
The terms profitability and cash flow are erroneously considered to be synonymous. Contrary to a layperson’s understanding that business owners take profit to the bank, profit is used to pay for any new equipment or materials needed for the business to grow, as well as for paying taxes.
Cash flow, on the other hand, refers to when a business needs money. Though essentially the result of a firm’s net income (with depreciation added back), cash flow is affected by balance sheet changes not necessarily routed through the statement of profit and loss. Transactions such as purchase of assets, repaying bank loans, taking out new bank loans and the like do not route through the profit and loss account. However, they affect liquidity considerably.
Law firm income statements provide a somewhat inaccurate picture of cash flow because they are predominantly prepared to reflect income and expenses for taxation. To prevent cash emergencies, the firm’s annual budget and a cash flow statement explaining the application of funds should be analyzed with great vigilance on a continuing basis.
MAINTAINING CLIENT RELATIONSHIPS VERSUS RECOVERIES
Lawyers usually perceive good client relationships and recoveries to be at loggerheads. Partners often hesitate to follow up for fees that have not been paid because they anticipate a probable risk of negatively affecting their professional relationships with clients over money matters.
Though the task of ensuring timely recoveries is usually placed in the hands of a firm’s finance professionals, each partner should be made aware of the monthly progress on billing and collections. Partners with unbilled amounts exceeding a specified limit for any client or matter should be called upon personally by the finance administrator to review unbilled time and accounts receivable. Creating peer pressure in this instance works in favor of the firm. Indeed, some element of the partners’ compensation system should be linked to cash collection so that partners are encouraged to bill promptly and follow up on accounts receivable.
Partners also generally have the best understanding of the time when clients will be most amenable to pay for legal services. Right after winning a motion in court, or drafting an important contract or closing the negotiation on a deal favoring the client, the client sits at the peak of the client satisfaction curve, where the resistance to paying fees is lowest. Firms need to take advantage of this knowledge.
Depending on the resources available, a law firm should outsource accounts receivable management to specialists. They have the expertise to consider and discuss discounts, banking arrangements and the like. Executing recoveries through professionals supervised by partners ensures increased cash inflow arising from prompt recoveries.
PLANNING AND BUDGETING
Firms must have a business plan outlining the strategies and initiatives that should be followed closely to reach their immediate and longer-term goals. The plan should address the issues with respect to investments, commitments and financial resources.
The next step is to prepare a financial plan or budget outlining projected revenues and expenses. By carefully analyzing past revenues from the firm’s top clients while budgeting, management will be able to detect trends and client needs that can be translated into assumptions and revenue estimates. Operating expenses and capital expenditures should also be given particular attention during this exercise.
Budgeting also enables firm management to control the use of services such as mailing, photocopying, telephone, postage, etc., and enhances the recovery of these expenses from the clients because each expense is earmarked and charged separately. The firm may decide to recover for these services by applying an average charge to each client, or it could bear these expenses as its cost of doing business. Whatever method is used, management must know the cost of these services, and must keep them under control to reduce the outflow of cash.
PROMPT BILLING PROCEDURES
Law firm management should understand the importance of establishing systems of internal controls so that checks and balances are interwoven within the procedures. Implementing robust billing operations ensures that all services provided are accurately invoiced and there is no possibility of leakage of revenue on account of lax systems.
Firms of all sizes have implemented centralized billing systems to replace lawyer-initiated manual billing. With centralized billing, computer software prepares the invoices, the responsible attorney reviews the invoices within a specified time, and the invoices are sent to the client. Combined with centralized billing, operational controls, such as reconciling the bills for court appearances with matter hearing lists issued by the courts, ensure that bills for court appearances are never missed.
Because most correspondence these days is sent via email, a firm creating a central monitoring team to monitor the inflow and outflow of email will ensure that all email messages receive responses. The billing team can pick up email data from the server and generate bills, almost on a real-time basis.
FLOW RELATED TO OUT-OF-POCKET EXPENSES
No matter how a firm accounts for expenses incurred on behalf of clients, they are certainly a drain on cash, and meeting these out-of-pocket expenses affects your cash flow adversely. Further, disbursements, such as photocopying, word processing/secretarial services, postage, telephone calls, office supplies and storage fees, are increasingly considered
to be a part of a firm’s overhead and are not reimbursed by the clients.
The firm’s administrator should assist the firm in keeping the costs to a minimum by comparing the costs associated with copying and printing done internally to those fees charged by an outsourced company to do this job.
Wherever possible, have the client pay the expense directly. This will mitigate the strain on cash outflow as the costs are routed directly through the clients. It also reduces the administrative costs of routing the payments. Expenditures incurred by the firm in connection with specific client matters should be reimbursed by the clients, in addition to any fees paid to statutory authorities.
PLAYING WITH THE CREDIT PERIOD
The trade-off between the benefits and the cost of liquidity requires firms to ensure that the collection and disbursement of cash are as efficient as possible. Decisions such as whether to take trade discounts or to stretch accounts payable should be based on a cost/benefit analysis of a firm’s credit policy.
An efficient way of improving cash flow is to slow down the outflow of cash by ensuring that payables are not paid until they are due. Many firms simply pay invoices when the invoice comes in the door—long before they are due. With careful planning, financial controllers would be able to create a sufficient gap between the credit period allowed to clients and the credit period availed from suppliers.
To sum up, I must emphasize that improved cash flow and profitability have a direct impact on the growth of a firm. By accepting some of the practices outlined above, fee-earners are able to focus on the performance and growth of the firm, while submitting themselves to systems and controls that manage the financial aspects of their practices in order to survive in the increasingly competitive environment. While systems and controls do not give you results in and of themselves, cash flow planning can help improve the monetary aspect of law firm management.