Finance: ‘Under the Hood Maintenance’: Time for a Profitability Tuneup?

Growing up, my dad was an executive with an automobile manufacturer and was never afraid to get his hands dirty working on cars. He was the quintessential “automotive guru” and was always drilling into our heads the need for “under the hood maintenance.” My siblings and I heard this mantra for years (but you had to appreciate the hand gestures that went along with it). It was always about taking proper care of our cars so they would continue to deliver the best performance. I cannot help but flash back to those days as we start 2023. It is a new year, a time to look back on the past year and consider making changes in our lives that improve our well-being or simply make us better people—we call them resolutions.

Law firms go through similar processes to identify ways to improve performance in areas like getting bills out faster or increasing accounts receivable collections or streamlining how we perform legal services to make them more cost-effective and efficient. We call these process improvement initiatives. Law firms, like automobiles, require regular maintenance checkups to perform at their best. Think of all the moving parts that determine the firm’s profit, from time entry, billing rates, operating expenses and collections. If cars have a set maintenance schedule, why should law firms be any different? As we start the new year, specifically the first quarter of 2023, it is an opportune time to check “under the law firm hood” and perform a little maintenance to make sure everything is in optimal working order going into the new year.

Regularly Review And Monitor Key Performance Numbers

Do not wait for “check engine” lights to appear on the firm’s performance metric dashboard. If firm personnel roll up their sleeves and check the basic moving parts monthly or quarterly, firms will be on top of any signs of problems instead of scrambling to fix them after the fact. There are many performance metrics to consider, and law firms need to discern those metrics/ tools that are most critical and support the firm’s performance objectives. Here are a few metrics that are particularly important to monitor:

Billing rates. Whether firms use hourly or blended (average or effective) rates, fixed fees or other fee arrangements, it is important to understand their effectiveness and the economics behind them. For example, when can firms bill premium rates? How do the firm’s rates compare to competitors? Too often, attorneys arbitrarily assign billing rates simply because “they sound right” and the client accepts them. Get to know your firm’s economic data and make decisions based on the numbers, not intuition. Billing rates should cover law firm operational costs and include targeted profit. Run the numbers and make sure the economics support the firm’s billing rates and other fee arrangements. Review benchmark surveys for billing rates among the firm’s competitors as well. Look at billing rates for similar-sized firms and practice areas and geographic areas to see how your firm compares. However, be careful to make sure you are comparing apples-to-apples information. Law firms tend to compare themselves to similar-sized firms alone, and that is not always a good metric. It is essential to compare your firm to others that are structured, leveraged and staffed like your own. Only then will the data be meaningful.

Realization. Realization is the amount of time billed and collected. This is critical, so firms should monitor both billing realization and cash realization very closely. Billing realization is the percentage of time billed to time recorded, while cash realization is the percentage of cash collected to time billed. On average, most billing realization should be in the 90% to 95% range or better. Assuming an hourly practice, when evaluating billing realization of standard rates, the general guideline to consider is whether the firm’s billing realization exceeds 97% or more on a regular basis. If it does, the firm’s standard or agreed rates may be too low. Conversely, if billing realization is below 82%, standard or agreed rates could be too high. These are simply benchmarks, but they can help firms gauge the effectiveness of their billing rates. The effectiveness of billing rates is determined by how efficiently a matter is being managed, which is reflected in time write-offs and write-downs. There is a billing rate and there is an effective billing rate. The difference between the two is the efficiency factor or realization. If billing realization is low, then too much time is being written off. This will have a significant impact on not only billings, but collection potential. If cash realization is averaging 100%, the firm is collecting what it is billing each month. However, if collecting accounts receivable is an issue, law firms will want cash realization rates more than 100% to make up for the efficiency shortfalls. Again, these are simply performance guidelines to consider when evaluating billing and collection realization trends. Regardless of which guidelines firms follow, collections should always be the priority.

Cash flow. This is the amount of cash collected to meet the firm’s cash requirements for covering operations. If the firm is not able to meet its financial obligations in a timely way, collections are an issue. It may be obvious, but surprisingly, collections are not always made a priority. Many attorneys would prefer not to be in the collection loop, but the reality is they need to be and/or need to assign someone in their firm to manage the collections on a consistent basis. The key is to stay on accounts receivable and move quickly to collect all overdue amounts. Have a collections plan in place ahead of time. The longer the accounts age, the less likely they will get paid. Also, delays in billing can adversely impact cash flow, so the key is to get your billing out as soon as the month closes. Billing that goes out early in the month, rather than slowly throughout the month, yields much improved cash flows and collections.

Leverage. Leverage has become more popular than ever. For law firms, leverage is the ratio of nonpartners (associates/of counsel/paralegals) to partners. Proper leveraging is achieved through process improvement and project management tools and methodologies, which in turn can improve revenues and profitability. Again, understanding the economics of the law firm and timekeepers will provide sufficient intelligence to properly assign legal work and maximize performance, revenues and profits.

Operating expenses. Monitoring expenses is important, and many firms work to reduce their expenses. But at some point, the exercise becomes futile. Unless firms plan to significantly reduce personnel, most expense cuts in operations do not yield much of a material impact on a firm’s bottom line. Most firms right now are in a revenue-building mode—the “top line” is where the law firm focus should be.

Law firms that take the time to regularly perform simple under the hood maintenance will see a boost in performance and profits. These “tool kits” will keep the firm running smoothly down the highway to success in 2023. More important, it would keep my dad off your back!