Summary
- Financial information comes from many sources, so you need a tool that can summarize it all to tell the overall story.
- How much income is a particular practice area generating?
Law Practice Today
Back to Basics with Finance
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Far too many lawyers and law firm leaders have said ... “Numbers are not my thing, and I’m just not a finance person.” Such beliefs are partially because accountants haven’t done a great job explaining the basics of law firm finance.
In this article, we seek to correct this issue by going back to the basics of law firm finance. We’ll make understanding finance a little less complicated, and who knows, maybe you’ll start calling yourself a ‘finance person’!
Tip #1 Where to Start
The best place for us to start is to recognize that financial numbers serve two main purposes for a law firm:
- To help you understand what is going on in the law firm.
- To help you make decisions that impact the future of the law firm.
When we keep these two factors in mind, it’ll make understanding finance a lot less complicated.
Tip #2 The Financial Story
Next, we need to understand that financial numbers come from different places. Eg. bank accounts, credit cards, loans, billing systems, payment systems etc. Since financial information comes from so many places, you need a tool that can summarize all of this to tell you the overall story.
Financial statements are tools that summarize all of your financial transactions, so you see the full story of your business. There are two core Financial Statements for a law firm, these are:
- Profit and Loss Statement (aka, P&L or the Income Statement)
- Balance Sheet.
The best way to understand these statements is to break them down into three sections.
The three sections for the P&L would be:
- Income/Revenue: How much money did the firm receive for its services?
- Expenses: How much money did the firm spend to manage the operations and provide services to clients?
- Profit: How much money is left after all expenses have been paid?
The three sections for the Balance Sheet would be:
- Assets: This is what the firm owns that has monetary value, Eg. cash, an office building, vehicles etc.
- Liabilities – This is what the firm owes to others, Eg. loans, credit cards, etc.
- Owners’ Equity – This is what value is left if you compare the total assets minus the total liabilities.
By understanding this, you can now use the financials to help you answer questions like:
- Is my firm profitable? (P&L profit)
- What are we spending most of our money on? (P&L expenses)
- How much money do we owe to other people and organizations? (Balance Sheet - Liabilities)
- Do we own more than we owe others? (Balance Sheet – Equity)
Tip #3 Examples and Use Cases
Now that you know how to use financials to understand the big picture, the next purpose is to use the financials to make decisions. When it comes to using financial information to make decisions, it helps if you have some level of detail. Let’s walk through some common examples:
Do we have enough cash to fund our business?
To answer this, you should look at your average monthly expenses (find this number in your P&L) and compare that to your total cash on hand.
If your average expenses (in your P&L) are more than your cash on hand, you either need to reduce your expenses in the future or bring in more income before your cash goes below zero (more billable work, more frequent billing practices, Collections processes for outstanding balances).
How much income is a particular practice area generating?
For this, you can look at your ‘income by case type’ or ‘practice area’. If you notice that some case types consistently have really low numbers, you can ask yourself if it’s worth it for your firm to keep doing that kind of work.
Here are some more advanced examples of using financial information to make decisions:
Should we hire more staff?
When deciding whether you can afford to hire more staff, you can use the financials (P&L income), to see how much money the firm received for its services and compare the number of staff members (Revenue per staff = revenue divided by number of staff). Then ask yourself what the revenue per staff would look like if we added a new person and how does that number compare to the cost of this new person.
A general rule is to aim for revenue to be at least 2.5x -3x the cost of your staff because the firm has to pay staff cost plus all other operating expenses. If your revenue is not at least in that range, you may need to start asking yourself: if we bring this new staff member on how much additional revenue should the firm bring in for this decision to work financially (for more specific insight, work with your accountant or firm CFO to help you analyze this for your law firm).
Should we change our marketing strategy?
To answer this, you could divide your total marketing spending by the # of customers to see your average Cost to Acquire a Client (CAC).
Next, you can compare that CAC to your average income per case. If your income is not at least 5 times more than your CAC, that typically means you either need to charge a higher price or improve your marketing strategy (this is a general guideline, so please work with your accountant to make this precise for your firm).
Conclusion
As you can see, the financial numbers don’t have to be complicated. In fact, they should be simplified and made more helpful to you.
Now, if you’re unsure about how to get the statements and the level of detail that we discussed, it would be in your best interest to work with a Bookkeeper/Accountant or a CFO. Once you have the financial statements, a CFO (fractional or full-time) can help you dig into the details to make better, financially informed decisions in your law firm.
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