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by David J. Bilinsky
It's critical to focus on financial analysis, rather than on the compilation of accounting data. The latter is about your history. The former means your future.
Despite the late 20th century rhetoric on how the practice of law has become just a business, running a law firm differs markedly from running a corporation. Sure, there are some parallels. But there are also key differences that forward-looking law firms will want to take into account. We can learn a lot by understanding the different financial tools and strategies corporations use to meet their goals and how to apply similar tools and strategies to our law practices.
Do you want to ensure that your firm has a healthy financial performance (and after all, shouldn't every lawyer)? Then it's time to learn how to accurately evaluate your earnings and make sounder operational decisions.
Where Financial Management Verges Down Two Roads
Corporations usually operate along tight financial management lines involving two broad decisions: the investment (or capital budgeting) decision and the finance decision. What that means is determining how much to invest, and in what, and how to raise the necessary cash.
A corporation decides to invest in a product only after carefully considering the proposed investment from a number of different review perspectives: marketing, R&D, finance, management and so forth. In contrast, a law firm often delegates the product (or service) investment decision to individual lawyers or practice groups, who then decide to take on or decline a file, thereby committing the firm to invest or not in the file.
In raising the necessary cash, corporations can access multiple capital markets. They can, for example, issue stock, issue debt or enter into private investments through venture capitalists. Law firms' access to financing, on the other hand, is largely limited to taking on debt or self-financing through capital infusion by partners.
When it comes time to evaluate financial performance, corporations look at break-even and risk-and-return analysis when deciding how to price a product. Contrast this to lawyers whose pricing decisions will just about reach to telling the client their hourly rate and opining on their legal chances of success on the file. Although some lawyers consider that pricing a file on an hourly rate basis passes on most financial risk to the client, the reality is quite different.
So, what can law firms do to better determine their financial opportunities and risks? CFO Research Services in collaboration with Cap Gemini Ernst & Young have published a white paper titled, "CFOs: Driving Finance Transformation for the 21st Century." (It's available on the Internet at http://www.us.cgey.com/news/current_news.asp?ID=249.) The findings stimulate thought for anyone who's serious about increasing a firm's financial performance.
The study looked at such companies as Allergan, American Express, Chevron Phillips, GE Capital and Intel. Companies that wanted to align their finance departments with the needs of the business had three top priorities:
Aside from hourly billing targets, how many law firms engage in revenue forecasting? How many go further and compare expected versus actual results on a file-by-file basis? How many use the accounting function to ensure that finite resources are applied to the most important opportunities? How many determine quantitatively if it's viable to maintain services in a legal area or to move to a more profitable niche?
Let's look at some ways that a law firm's finance function can work actively to increase the financial performance of the firm. Along the way, let's also examine how some key financial concepts apply in the law firm environment.
Net Present Value: How Time Affects Your Investment in Your Files
What is net present value (NPV)? And why should lawyers care about it? Well, NPV is about the value of money over time. Think about the old expression: "A dollar today is worth more than a dollar tomorrow." In other words, if you agree to forego a dollar today in return for a dollar tomorrow, then you should be rewarded for the lost opportunity of investing that dollar.
Let's assume that you have two lawyers working in a firm. The first lawyer works on a file that will yield $100,000 a year from now. The second lawyer works on four successive files that will yield a total of $100,000 over the same time period. However, most firms and firm compensation formulas do not distinguish between the two lawyers and the money value of those files over time each lawyer would be credited with realizing $100,000. The fact that the firm had to invest in one file for a much longer period is simply overlooked as is the point that the firm should consider the value of the investment in files with long maturity periods.
Let's consider the concept of present value (PV) in more detail:PV = discount factor x C1,where C1 is the cash realized on the file after time period 1. The discount factor is expressed as:Discount factor = 1 / (1 + r)n,where r is the rate of return and n is the number of time periodsThis leads us to: NPV = PV - required investment
By way of an example, let's assume that you have two files, both of which required an $85,000 investment by the firm (in present dollars). That investment represents the total of all costs (fixed and variable, including lawyer time) that the firm had to put into the files. Assume that each file produces $100,000 in revenue
You then have:NPV = C1 / (1 + r )n - C0,where C0 in this case is $85,000, because it represents the investment in the file, and C1 represents the revenue.
Now, for our example, let's assume that the discount rate (which includes a risk factor) is 10 percent per annum, which is approximately .797414 percent monthly.
A file that takes three months to complete in today's dollars (NPV) is worth:NPV = $100,000 / (1 + .0079714)3 - $85,000 = $12,646.21
A file that takes one year to complete in today's dollars (NPV) is worth:NPV = $100,000 / (1 + .1) - $85,000 = $5,909.09
If the firm is fortunate enough to be able to pick and choose its files, it should at the outset evaluate them from an NPV perspective as well as from a legal merits perspective.
When determining draws and bonuses, most partner contribution and compensation formulas usually don't consider the delay in receiving revenues namely, the period of time over which the firm had to invest in the file to properly reflect the discounted value of the dollars received later in time. The formulas should discount the gross revenues of each file to adjust for the fact that the revenues have been received over different time periods and, further, that the longer a file is outstanding, the greater the potential risk factor of that file.
Break-even Analysis: The Bottom Line for Each Matter
To really understand and increase financial performance, law firms should also determine the break even point for specific types of files and different types of clients. This is relatively straightforward for commodity work such as repetitive transactions, provided that you're willing to track the variable and fixed (allocated) costs that go into the file. Once you gain some experience with this, you can extend the analysis to more complex files.
Let's start with a simple example. Assume that you do only incorporations work and your office personnel consists of yourself and two secretaries. Because the third-party disbursements incurred in the file (search and registration fees, couriers and the like) are recovered from the client, let's ignore those for the purposes of this analysis.
Say that you pay each secretary $30,000 per year, including all benefits. Each secretary can do 25 incorporations per month on average. Each secretary's cost per file is then:$30,000 / (25 x 12) = $100 on the average file
Next, let's assume that you and the two secretaries use 2,000 square feet of office space at $25 per square foot per year (all-in). The rental costs per incorporation file are then:(2000 x 25) / (25 x 12 x 2) = $83.33
In addition, each secretary uses a computer-printer system that must be replaced every three years at a cost of $4,000. The cost of the computer system to the file is then:$4000 / (25 x 12 x 3) = $4.44
Now, assume that the file's share of all other costs in the office (telephone system, banking costs, accounting services, paper and supplies, cleaning and janitorial costs and so forth) comes to $25 per file. Therefore, even before calculating your costs into the file, the total office costs in this case are:$100 + $83.33 + $ 4.44 + $25 = $212.77
Having determined that sum, let's calculate your costs per file. Employing two secretaries allows you to do 50 files per month in total. You desire an income of at least $150,000 before taxes. Your desired return per file is then:$150,000 / (50 x 12) = $250
The total costs per file then come to:$212.77 + $250 = $462.77
This is your break-even point. If you do an incorporation for less than $463, you are losing money on the average file. (The trick is either to select better clients from the outset, ones that can pay more per file, or to set up a variable pricing scheme charging a higher fee to capture the additional work for more complex incorporations.)
What-If Analysis: How Any Given Change Can Make Its Mark
Once you start doing the preceding type of analysis, you can soon determine your bottom line or break-even point for each type of file that you handle. The next step: Having done the financial modeling by building your cost structure in a detailed spreadsheet you can then perform "what-if" analysis. In other words, if you change something, how will it affect your break-even point?
Moreover, if you're ever pressured to do work at below your break-even cost "to keep the client," you're faced with another what-if proposition. You should do more than simply factor in the marginal cost of this action that is, the difference between what you would have charged and what you did, in fact, charge. Remember: The reduction comes right off of your target income level, which was $150,000 in our earlier example. So, while your costs remain the same, the margin on each file must go up to maintain the same income level. This might not be a big deal if it's only an occasional occurrence. But combine a number of these "freebies" with accounts that have to be written off or written down, and you can see that your average fee for your remaining files must rise dramatically if you wish to maintain your $150,000 assumed income. (Another way of looking at this is to group all matters for a client together to determine if you're getting a fair return from that client. If not, take steps that will net you a fair return, or over time encourage the client to go elsewhere.)
You're better off putting your time into marketing or client development than into files that not only reduce your bottom line but also work against it.
The Value that Change Creates
NPV and break-even analysis, along with other financial tools, can significantly help a law firm in determining accurate earnings and operational decision support. From there, firms can develop a solid financial plan that includes revenue forecasts and leads to the formulation of wise firm strategies. (See the sidebar for pointers on financial plans.) It will take some work, but you'll start to transform your accounting function into a true finance function, just like the companies that participated in the Cap Gemini Ernst & Young study.
What can you expect from such a transformation? The Cap Gemini study found that reformed finance departments took active strategic roles in profitability analysis, partnering decisions, pricing decisions and demand forecasting. This meant developing financial and nonfinancial measures to support the implementation of strategy.
Cap Gemini also found that, in the handful of companies that have transformed their finance departments, the results have been worth the effort. They reported that they achieved a lower cost of finance and, more importantly, a greater strategic contribution from their finance departments. Once success was demonstrated, the projects met with greater support as people began to see the value that change creates.
By doing the same, you can target specific ways to improve your firm's performance. And by implementing a better way of doing things, you can ensure that there is more than just a lot of nothing left over at the end of the fiscal year.
What Should You Put In Your Firm's Financial Plan?
The first elements are pro forma (forecasted) balance sheets, income and expense statements and statements describing the sources and uses of cash.
The financial plan must also address the twin issues of financing and investing (the capital required for the upcoming period and how it's to be raised). This ensures that partners understand how they must either forego draws or increase debt to meet the required capital infusions.
The plan should also deal with how the partners will be rewarded for their capital investments.
In addition, it should describe why you are undertaking capital expenditures (after having explored the what-if scenarios open to the firm) and the business strategy for those expenditures (to achieve greater throughput, for example).
Finally, you must incorporate financial measures and analysis to establish your costs, break-even points and revenue determinations, to find out if your business strategy is working.
David J. Bilinsky (firstname.lastname@example.org) is the Practice Management Advisor and staff lawyer for the Law Society of British Columbia. A past co-chair of ABA TECHSHOW, he is the current chair of The Pacific Legal Technology Conference.
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