The financial health of your law firm ultimately depends on how well you manage cash flow. From budgets to billings, there are ways to keep your firm in the black even in these tough times.
Law firms are businesses, businesses need cash to operate, and cash is tough to come by during a combined recession and credit crunch. That dilemma faces law firms of all sizes today in both Canada and the U.S. The Canadian experience has not been quite so harsh, in part because lenders and law firms in Canada were not so irresponsible as their American counterparts. Even so, the financial health of any law firm, in any business environment, ultimately depends on the cash management function – and too many firms ignore that truth at their peril.
A recent story in the New York Times about the financial troubles of a major Wall Street firm put the issue succinctly: “Remarkably like such ventures as the Mafia or the ice-cream vendor, many large [law] firms operate on a cash-in-hand basis, with insufficient reserves to weather a slump.”
How much cash do you need?
There is no mystery about how much money a law firm needs to survive. Four factors are crucial:
- Volume: The greater your billings, the greater the need will be for cash in the firm. That’s because the time between when you send out a bill and when you receive payment averages more than four months nationally. The more client invoices you have outstanding, the more cash you’ll need while waiting for payment.
- Growth Rate: Faster growing firms will likely need more money for supplies and equipment, attorney and staff support, and office space. While you’re waiting for clients to pay you, vendors, landlords and utilities expect payment immediately.
- Capital Turnover: This defines how often the invested assets of the firm are being returned in revenues. Higher rates of turnover produce more revenue on the same amount of assets. You should review your receivables weekly to see who has and hasn’t paid. Never wait until the end of the month to check turnover – that loses 30 more days in getting the cash you need.
- Credit Terms: The more lenient your terms to clients, the more cash you’ll need while waiting payment. Conversely, tough credit terms (such as charging interest on unpaid balances) are likely counterproductive – clients who won’t pay their bill won’t pay the interest, either. Never give in to the temptation to extend credit in the hope that the client will give you more work. Strive to get paid quickly for the work that has already been done.
How do you keep track of it?
It’s one thing to identify these financial variables, and quite another for most firms to keep track of their impact. Today’s financial information systems and software can and do produce far more data than a lawyer can use or assimilate intelligently.
To avoid information overload, the best way to view your firm’s cash position is to develop a cash flow statement, a forward-looking budget of cash receipts and payments for the next 12 months. Keep that statement on a rolling 12-month cycle such that as you conclude the current month, you look at the 12th month and add it into your budget, adjusting all the other months if needed based on new information.
As part of this process, relating back to collections, keep your accounts receivable listing always at your elbow to make sure that your clients are paying you in accordance with their agreement. If you do these two things, you will be far ahead of the financial curve compared to most firms.
When you get to the point of adding up the numbers, there are two basic methods for keeping track of the money,: accrual versus cash accounting.
Accrual records reflect income and expenses irrespective of whether cash has been collected or paid. In other words, accrual accounting reflects billings, work in progress (completed but not yet billed) and accounts receivable (work billed but not yet collected).
Cash accounting, on the other hand, reflects only collections, never billings or work in progress. Almost all small law firms operate on a cash basis, accounting for cash as it comes in and goes out. Larger law firms maintain both cash and accrual records.
How should you realize it from billings?
The only way to get income is to bill in a regular and timely way, using statements that contain a full narrative of the work done and the goal accomplished by that work. The more information that the invoice provides about what was done and what that work accomplished, the more likely the client will be to perceive the bill as fair and to pay it promptly.
Break any broad charge into its basic elements, with the amount of time needed for each: review key documents and deposition testimony, draft statement of uncontested facts as required by court procedure, research precedents in four similar cases, and so on. Such itemization does not try clients’ patience – it helps them understand just how much was done on their behalf. Use action verbs to describe services and clearly indicate the specifics of what was accomplished. This gives clients an appreciation of the effort required for success.
Once bills have been sent out, closely track clients’ payments. Review accounts receivable once a week, determine which clients are behind on their payments, and pursue collection with regular weekly reminders that money is owed to you. Forgetting or ignoring "“old”" clients results in forgetting or ignoring the accounts receivable. This results in the failure to collect outstanding bills and dramatically lowers cash flow.
It cannot be emphasized too strongly that the best way for law firms to maintain cash flow is to promptly collect the billings due to them. In today’s economy, more than ever, firms should not be banks that carry their client’s’ accounts.
Stipulating payment rates and terms in the engagement agreement is the best way to get paid. This is particularly true when the client accepts a budget and understands what to expect, which significantly increases the chances of collecting the fee. Shared expectations, effective communication and dependable follow-through by law firm and client all define the kind of good relationship that results in collecting a higher percentage of the firm’s billings.
Don’t proceed on a vague hope of being paid as expenses pile up. The engagement letter should clearly state the consequences to the client for failure to honor the agreed-upon payment commitment. Keep track of when clients are behind on their payments, and be firm in requesting payment.
There are additional tactical steps that any firm can take to get their fees paid and into the bank quickly. Here are just two examples of innovative tactical tools that any firm can use.
- Take advantage of the new check cheque scanners to more quickly and securely deposit client checkscheques. Scanners treat a check cheque virtually as a debit card, making deposits available to you far more quickly.
- Close your billing on the 25th day of each month to get bills into clients’ hands faster. This improves cash flow because clients receive statements before the first day of the following month, when many people and companies pay bills. A bill that comes after that is frequently kept for payment until the following month. As an alternative, bill one-fourth of the alphabet each week, creating a rolling income stream that evens out cash flow over the month.
How can you get it from the bank?
Note that our emphasis on cash management has all been on the collection function, which after all is what lawyers can directly control.
Law firms do have credit lines, in which the firm borrows and repays at will up to the amount of the credit line; but, given the headlines about lawyer and staff layoffs, banks may be reluctant to give credit to any law firm customer. This is particularly true because credit line terms can fluctuate substantially, however the bank dictates.
Consider a term loan, which can be as long as seven to ten 10 years for a large law firm, three to five for a smaller one. But banks today have stricter standards to make for making such loans.
It’s important to remember, especially in this era of tighter credit standards, that bankers view and understand any law firm as a business, with cash flow, receivables, revenue and profits. Lawyers should educate their bankers on how their business operates in order to build a relationship of trust. That means documenting clear plans for cash and receivables management, and marketing and business growth.
It also means confirming your status as a reliable borrower by having a high credit score on any of the various systems used. All this should be established before the firm ever needs to seek a loan. Then, when “crunch” time comes, the foundation established will be one on which the firm and the banker can rely in a loan transaction.
How to find true happiness
Much of this discussion involves technical issues, but more important than any of them is the fundamental principle of living within your means. That requires a personal/professional expense hierarchy with these levels: practice needs, personal needs, savings for slow periods or emergencies, and personal income after all other expenditure needs are met.
Practice needs should always come first, and personal needs should be the most flexible category. Personal needs, as covered by the lawyer’s “draw,” should be the minimum expense necessary to maintain your standard of living. If the practice produces sufficient income to increase your standard of living, fine. But the better approach is to avoid committing yourself to extensive obligations not supported by your cash flow. Remember the principle Mr. Micawber established long ago: “Income 20 pounds, expenses 19 pounds, result happiness. Income 19 pounds, expenses 20 pounds, result misery.”
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