September 01, 2018

Understanding Your Firm’s Real Financial Condition

A how-to guide for gathering key financial data for your firm so you can know its true profit or loss.

Ariela Tannenbaum

When it comes to financial performance, most small to midsize law firms focus on their ABCs: Accounts receivable (keep ’em low!), Billable hours (keep ’em high!) and Collections (100 percent would be nice!). But true “financial intelligence”—and the success that flows from it—requires more. It’s not enough for firms to zero in on a snapshot of these three predominant measurements of financial success because, while important, they only tell part of the story.

Imagine yourself driving a car but only able to see what appears in your rearview mirror; no forward view of the road beyond, no speedometer, tachometer, gas gauge, navigation system, compass, thermometer, park assist—you get the picture. You might have a pretty clear sense of where you’ve been, but where you’re headed, and the hazards that lie up the road, are anybody’s guess. Likewise, a law firm may have a highly competent bookkeeper, accountant, controller or even a chief financial officer to serve the essential role of digesting reams of accounting data and presenting a picture of the firm’s past financial performance to leadership.

Your Practice Is a Business

But what is too often lacking is true financial intelligence—a forward-thinking, strategic plan that goes beyond the “What have we billed? What have we collected? What are we owed?” paradigm that inevitably leaves you one step behind. What is financial intelligence? It is a powerful tool that top-level executives in the corporate realm have long utilized to maximize profits. Fortune 500 companies have long relied on sophisticated financial tools to chart their financial success, and those same tools can be scaled and applied to law firms. These tools allow a law firm to:

  • Convert accounting data into management insight.
  • Accurately project future financial performance.
  • Dive into financial health and profitability trends by practice area, office, client and industry.
  • Identify profitability levers.
  • Gain clear visibility into the firm’s strengths and weaknesses.
  • Develop concrete plans to enhance profitability.

But before you can put these tools to use, you must stop seeing the law firm as a practice and start running it as a business—a profit-driven entity with a forward-looking vision and a realistic, operative plan for success. Consider whether you can answer the following questions in confident detail:

  • What is the profit margin of the firm?
  • What is the profitability of each one of the practice areas?
  • What has been the profitability trend by practice area over the last three years?
  • What is the projected profitability?
  • Do you have an actionable plan to “fix” the weaker practice areas and enhance the stronger ones?
  • How do you optimize pricing in response to the increasing demand for alternative fee arrangements?
  • What is the revenue loss associated with discounted billing hours and rates? Is there an upward or downward trend?
  • What is the profitability of your top 10 clients?
  • How will a potential departure of a partner impact bottom line profitability?
  • What is your firm’s financial outlook for the next six to 12 months?

A managing partner who cannot answer these questions will never break out of the all-too-common cycle of perpetually playing Monday morning quarterback.

So how do you arm yourself with the data needed to answer these and other key questions and finally break out of the backward-looking cycle once and for all? You employ the corporate world’s sophisticated financial tools to convert your accounting data and trends into management insight. This will allow you to concisely identify the direction your firm is heading, its strengths and shortcomings, the risks and opportunities, so that you can consciously and purposefully act to increase profitability.

To truly run your firm as a profit maximizing business, you must have a pragmatic, yet holistic, overview of the firm’s operations, and be thoroughly informed, at all times, of all performance indicators—so you can take prompt, decisive action to stay on course to meet your financial objectives. This requires a multistep process.

The Budget and Regular Financial Reviews

As a starting point, it’s imperative that a firm develops an annual financial budget that mirrors its strategic plans. Mission statements, vision declarations and strategic plans have little value unless they are accompanied by measuring mechanisms. The budget creates a sense of commitment and a measurable indicator for the leadership of the firm. For the budget to be effective, it needs buy-in from all stakeholders, and an all-hands budget development process is therefore ideal.

While the budget is a critical starting point, it’s not enough. Firm management needs a disciplined monthly or quarterly financial review, which should include the following topics:

  • A clear picture of the firm’s financial health, that is, year-to-date profit and loss results.
  • Precise financial projections and reasons for any variance from the budget.
  • Revenue, profitability and profit margin by major drivers: attorney, practice area, industry, client and office.
  • Revenue analysis of both hourly and alternative fees.
  • Expense analysis, including expense drivers.
  • Profitability and profit margin per (significant) matter.
  • Productivity drivers and trends by attorney and practice area, both in individual offices and firm-wide.
  • Impact of potential upside/downside on profitability.
  • Profitability levers.
  • Impact of changes in hours and fee rates on revenue.
  • Benchmarking.

The monthly or quarterly financial review should ideally be in person and include the senior leadership of the firm and a finance professional. The discipline of a formal, in-person meeting and discussion of the financial review provides the firm management a platform to best realize and discuss the financial impact of the operational strategies and adjust them as needed. It empowers management to make decisions with conviction, and it is a pre-emptive approach proven to mitigate risks and stabilize the firm’s bottom line.

Looking Back or Looking Ahead?

While a law firm can and should be run like a business, you can never lose sight of the type of business it is and the unique dynamics that influence financial success. For example, measuring attorney billable hours and total revenue production is important for last year’s productivity. But to optimize future productivity, one must look at the intersection of utilization rate by attorney and realization rate. The future earnings of the firm depend largely upon the attorneys with highest utilization and realization rates.

But, first, what do “utilization” and “realization” mean in this context? Both utilization and realization rates are key performance indicators in measuring productivity in law firms. Utilization measures the efficiency of attorney time. The utilization rate simply measures the time an attorney spends on serving a client versus the time the client is billed. For example, an attorney spends 100 hours on a client matter but bills only 80 hours. His or her utilization rate therefore is 80 percent on this matter.

The realization rate refers to the difference between the standard billing rate and the actual fee paid by the client. For example, an attorney’s hourly billing rate is $500, but the collected fee is $450 per hour. The realization rate is $450 divided by $500 or 90 percent. Clearly, looking at utilization and realization on an annual basis can provide a clear picture of the productivity level at the firm.

Some attorneys bill a large number of hours but perhaps at lower hourly rates or at low collection rates. Others may have high hourly and collection rates but lower gross billable hours. Understanding and measuring the intersection between these factors tell you which lawyers in your firm are contributing most to your bottom line. And true financial intelligence provides this information to firm management in an easily digestible graphic format.

One billable hour with the highest utilization and realization rates results in more value to the firm than multiple billable hours with low utilization and realization rates. In fact, the latter hours are a drain on the firm’s resources. Clearly, it’s in the firm’s best interest to maximize the number of billable hours that shine in both measures. To this end, proper coaching, mentoring and promoting those people—and training others to emulate them—will drive up profits.

Understanding and Optimizing Pricing

In the context of optimizing performances and enhancing the bottom line, the analysis must include a consideration of pricing.

Take, for example, fixed-fee pricing. In a recent conversation with a senior partner of a well-reputed firm, when I asked about how his firm set a fixed fee for any given client matter, the partner shrugged his shoulders and remarked casually, “I come up with a number. It is a ‘go’ or ‘no go’ depending almost entirely on the client budget.”

That is one way of going about it, of course, but as fee pressure increases, this casual method becomes less advantageous, especially for large matters. It becomes imperative to optimally price matters—high enough to be profitable and low enough to be competitive.

One approach is to estimate the number of hours involved and identify the corresponding compensation cost. To properly compute the compensation cost, it’s important to assign a certain level of compensation per partner. As a benchmark consider the base compensation of an executive at a similarly sized corporation. The second level of cost is associated with overhead allocation. The third level to be considered is harder to measure precisely; it’s the cost of the risk of unknown complication(s) that might arise. And, lastly, a profit margin should be applied. When computing a fee in this fashion, the firm can easily quantify its minimum fee, the “glass floor.”

The glass floor should never fall below the compensation cost and must cover a certain percent of the overhead cost. When examining pricing from this angle, a firm’s ability to offer competitive yet profitable pricing crystallizes.

Additionally, to mitigate risk, one ought to communicate pricing effectively with the client and precisely describe all elements included in the quoted price (i.e., the anticipated number of depositions, the anticipated hours involved in drafting an agreement) but also include a “collar.” The collar sets a more specific ceiling and floor to the price. For example, a 20-percent collar means that if the cost associated with the matter is 20 percent over the quoted price, the client has to pay the cost over the 20 percent at a (potentially) discounted rate. If the cost is lower than anticipated and drops below 80 percent of the quoted price, the client is rewarded the difference.

While this particular illustration addresses fixed fees, this same pricing approach should apply to all matters, from traditional hourly to full contingency arrangements. While the analysis may change slightly, the fundamental variables—compensation cost, overhead allocation, risk and profit margin—are the same.

Change Is Hard, but It’s Worth It

While I strongly agree with legendary business guru Peter Drucker that “what gets measured, gets improved,” one must be careful not to drown in too much analysis. The term “analysis paralysis” stems from reality. Make sure to measure only what is most relevant to your firm. An analysis of hourly rate pricing is of little value to a firm that handles cases solely on a contingency basis, and vice versa.

The growing level of complexity and the sophistication in the legal field, coupled with all external forces acting on it—rising competitive pricing, the increase in demand for alternative fee arrangements with imbedded financial risks, the decreases in realization rates, a rise in alternative service providers and the shifting of work to in-house legal departments—is presenting a significant challenge to the legal field. The days in which law firms operated in a profit paradise and could afford to eschew deep financial analysis are fading fast.

As law firms have come to realize the uphill battle to preserve margins and enhance profits, they have enriched their talent pool with marketing and technology professionals. But too many law firms still leave money on the table, though they don’t know they do and certainly don’t know how much. I do bear some good news: Lawyers don’t need to work any harder or smarter, but they need to view themselves as businesspeople and run their practices like the successful corporations they represent. It’s time to take another step forward and see the firm though the clear and concise financial lens, unlocking the management insight you deserve to enhance your firm’s performance.

Of course, change is hard. Moving beyond the ABCs to a true holistic picture of a firm’s finances, a sharp and deep X-ray-like picture, can sometimes spark delicate and potentially explosive intrafirm politics and a diversion from its objectives. It is prudent to have a third-party consultant approach the analysis with a truly objective outlook, a fresh corporate world perspective. The resulting analysis should present to you a measured assessment of the firm’s present state, the financial impact of operational strategies, a detailed plan of how to reach its financial objectives and a clear path to maximize profits.

Ariela Tannenbaum

CEO, Advanced Financial Analytics LLC

Ariela Tannenbaum is the CEO of Advanced Financial Analytics LLC and a principal of Edge International, a law firm and consulting company that is leading the evolution of the legal profession worldwide. Advanced Financial Analytics is a consultancy firm focusing on enhancing law firm profitability. Her practice includes financial forecasting, budgeting, expense management, compensation, partner’s profit distribution, resource allocation, fee optimization, benchmarking and risk/opportunity assessment. ariela@afa4law.com

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