While our focus is often targeting increased revenues and profitability, the summary of performance provides information at a higher level as to how revenues and expenses interact with the firm’s assets (cash, accounts receivable, client cost advances) and with firm liabilities (bank debt, employee benefits, taxes, accounts payable). The end result is a cumulative assessment of the firm’s value whether it be a partnership (capital) or a corporation (retained earnings).
A summary of performance for any business, law firms included, must be set forth in a consistent, uniform and structured format—I often refer to this presentation as the “report card.” The two summaries alluded to above are otherwise known as financial statements—the balance sheet and the income statement (profit/loss).
Setting the Report Card Standard
Financial statements maintain consistency and uniformity in reporting based on generally accepted accounting principles referred to as “GAAP.” Because financial institutions on all levels review business financials for the purposes of valuing a business, extending financing for growth and expansion, and for many other reasons, there needs to be a presentation standard in which financial information is reviewed and analyzed. GAAP starts with a conceptual framework of standards that anchor financial statements to a set of principles such as:
- Materiality—the degree to which the transaction is large enough to matter;
- Verifiability—the degree to which different people agree on how to measure the transaction.
The fundamental goal is to provide users—law firm management, investors, creditors—with relevant, dependable and useful information for making good financial decisions. Financial statements assist in better understanding the law firm. They can aid in improving business performance by allowing the firm to make informed decisions on fact rather than instinct or speculation.
The balance sheet is a statement of the financial health of the firm. It is broken down into assets, liabilities and equity (capital or retained earnings). Most relate the balance sheet to the formula referred to as: Assets + Liabilities = Equity.
Assets are items of value owned by the firm that create future cash flows. Items include cash, accounts receivable, client cost advances, investments, prepaid expenses and equipment.
Liabilities are firm financial obligations that function as a source of support for the assets and require future cash flows. Items include accounts payable, payroll taxes, lines of credit and bank loans (current and long-term debt).
Equity is the amount owed from the firm to the shareholders or partners and is also another source of support for the firm’s assets. It is sometimes referred to as “shareholder equity” and calculated as follows:
- amount shareholders/partners invested (+);
- firm’s earnings or losses since inception (+);
- additional contributions from shareholders/partners (+); and
- distributions or withdrawals made from shareholders/partners (-).
If the above calculation is negative, the firm will have a deficiency instead of equity—also referred to as (negative equity).
While a balance sheet may at first appear to be a simple list, it is a key part of the language of business that can assist law firms in understanding the firm’s liquidity risk (Does the firm have enough liquid resources to fund operations?) and leverage risk (Does the firm have too much debt and hence too much risk?).
The income statement measures a law firm’s performance over a specific period and presents information about revenues, expenses and profit that was generated because of the firm’s operations for that period. While the balance sheet is a point-in-time snapshot of what the law firm owns and what it owes and the residual equity the owners have in the firm, the income statement is like a movie—it illustrates what the law firm has done, measuring inflows and outflows for a period. Income statements should be produced regularly and compared against previous months’ activities to ensure the firm’s profit expectations are being met, and if not, why?
What About the Cash Flow Statement?
Most law firms focus solely on the balance sheet and the income statement, but there is a third statement that reconciles the other two and provides a considerable amount of valuable information. The statement of cash flows illustrates the increase and decrease in cash over a period that the law firm creates as it operates. The period is usually the same period as the income statement.
The statement of cash flows is the most intuitive and groups cash inflows and outflows into three categories. These categories provide valuable insights into why the amount of cash has changed and how the amount of cash might change in the future.
- Operating. Operating cash flow is the net increase or decrease in cash created by normal law firm operations. Most law firms present operating cash flows by starting with net income and adjusting income for items that do not affect cash, such as depreciation and client cost write-offs. This part of the cash flow statement reconciles net income to actual cash the firm received from or used in operating activities.
- Investing. The second part of the cash flow statement illustrates the cash flows from all investing activities, which include purchases or sales of long-term assets such as property and equipment, as well as investment securities.
- Financing. The third part of the cash flow statement illustrates the cash flow from financing activities. Typical sources of cash flow include cash raised by selling stock or borrowing from banks. Likewise, paying back a bank loan would also show up as use of cash flow. The statement also includes cash paid for interest and taxes.
It is important to note that while cash flow statements reconcile to the income statement and balance sheet, profit does not equal cash flow. Many law firms have shown profits on their income statement but struggled later because of insufficient cash flow. The income statement may note a profit of $100,000, but that does not necessarily mean the firm has $100,000 sitting in the bank. Cash flow can be higher than profit or lower. Also, cash flow can be negative when there is profit, and vice versa. There is no correlation between profit and cash flow, which is why a reconciliation of operating cash flow to net income is essential.
Financial Statements: Bringing It All Together
One of the important takeaways is that the balance sheet, income statement and statement of cash flows are all related. The changes in assets and liabilities that are seen on the balance sheet are also reflected in the revenues and expenses on the income statement, which results in the law firm’s gains and losses in cash flows. Cash flows provide more information about cash assets listed on the balance sheet and are related, but not equivalent, to net income shown on the income statement.
In future columns we will take deeper dives into law firm financial statements and the benefits they provide for making good business decisions. As we continue to focus on performance metrics and all the other important ingredients to generate revenue and profit for our law firms, we need to be able to learn the business language associated with financial statements so we can interpret the law firm report card and understand where and how we can improve overall business performance.