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Small Firms Division

Consider your cash requirements for the year ahead

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Many firms don’t worry about cash until it’s too late, says Andy Poole. He explains why you should be constantly reviewing your cash requirements throughout the year, starting with your most important asset - your people.

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The new year is the perfect time to take stock of what you and your firm wish to achieve in the coming year. As a firm, you may be planning an office move, looking to move software in preparation for making tax digital, or just looking to improve efficiencies.

Whatever stage the business is at, you should be constantly reviewing your firm’s working capital requirements. Do you have a high level of work in progress (WIP) that is likely to result in a strain on cashflow? You may have considered all of these things in isolation, but unless you are able to integrate all the data in a format from which you are able to make informed management decisions, things can take longer than anticipated to determine the most appropriate actions.

Most law firms track performance of the firm and its individuals based on revenue generation. There is an age-old adage that revenue is vanity, and profit is sanity, but cash is reality. Too few firms worry about cash until it is too late: when law firms go out of business, it is usually down to running out of cash. To make informed decisions about their future, firms need to track what is available to bill and cash recovery.

Obviously, there are significant cash outflows in any business that require tight management, such as property rents, salaries and partner distributions. In most law firms, these costs are often fixed or relatively stable. Focus then switches to cash inflows. From an inflow perspective, the main driver behind a late, part- or disputed payment is often the mismatch of expectations between the law firm and the client. If there is no budget set; no detailed understanding of what is required by all parties in producing a piece of work; and no clear understanding of what will be billed and when, there will be awkward conversations with the client, which will ultimately impact payment.

The role of the commercially minded lawyer is to keep clients informed as a matter moves through its phases, tacking progress and managing the budget. This will then work better towards better, tighter and faster cash collection.

A law firm applying this type of approach at a client or matter level should be able to scale the concept up to the wider business. Most firms are able to predict what expenses they will incur; when they will be incurred; and what income they hope to generate. This allows them to see what level of profit (or loss) they expect for the year. A substantial number of firms have this information available to them, but very few integrate this information in one place, which would allow more efficient management decisions to be made.

As service businesses, people are the most important asset of any law firm. Using people as the starting point for any forecast or budget model allows you to first know what you are going to pay each of them, and also what you expect in return on a person-by-person basis. If you know the work this employee will be doing, you will be able to predict what billable time will be recorded, and then crucially using individualised targets for WIP days (the time between doing work and raising a bill) and debtor days (the time between raising a bill and getting paid), you should be able to accurately predict when bills will be raised and paid.

Below are two worked examples illustrating this point.

Worked example 1

  • A fee-earner is paid a salary of £48,000 (to keep this simple, we will assume no bonuses or performance incentive schemes).
  • They work 35 hours a week, 45 working weeks in a year.
  • 70% of this time is charged to clients as billable.
  • Their charge-out rate is £250.
  • 80% of billable time is recovered.
  • They raise bills every two months.
  • The firm’s payment terms are 28 days, and all clients pay on time.

Workings

Hours charged to WIP each month = (35 hours x 45 weeks x 70% utilisation x £250 charge rate) / 12 months = £275,625/12 = £23,000

Fees raised every two months = £46,000 x 80% recovery rate = £36,750

Profit and loss account    

 

For month ending X

Month 1

£

Month 2

£

Month 3

£

Month 4

£

 

Fee income

0

36,750

0

36,750

 

WIP movement

18,375

(18,375)

18,375

(18,375)

(see balance sheet below)

Office rent

(3,000)

(3,000)

(3,000)

(3,000)

 

Salary cost

(4,000)

(4,000)

(4,000)

(4,000)

(PAYE/NI/pension ignored)

Profit

11,375

11,375

11,375

11,375

 
      

Balance sheet

     

 

Work in progress

Month 1

£

Month 2

£

Month 3

£

Month 4

£

 

Brought forward

0

18,375

0

18,375

 

Time charged in month

23,000

23,000

23,000

23,000

 

Billed in month

0

(36,750)

0

(36,750)

 

Written off in month

(4,625)

(4,625)

(4,625)

(4,625)

 

Carried forward

18,375

0

18,375

0

 
      

Debtors

     

Brought forward

0

0

36,750

0

 

Billed in month

0

36,750

0

36,750

 

Received in the month

0

0

(36,750)

0

 

Carried forward

0

36,750

0

36,750

 
      

Cash at bank

     

Opening bank balance

30,000

23,000

16,000

45,750

 

Received - debtors

0

0

36,750

0

 

Paid – office rent

(3,000)

(3,000)

(3,000)

(3,000)

 

Paid – salary costs

(4,000)

(4,000)

(4,000)

(4,000)

 

Closing bank balance

23,000

16,000

45,750

38,750

 

All circumstances are the same as in worked example 1, except that:

  • They raise bills on a monthly basis.
  • The firm’s payment terms are 14 days, and all clients pay on time.

Workings

Hours charged to WIP each month = (35 hours x 45 weeks x 70% utilisation x £250 charge rate) / 12 months = £275,625/12 = £23,000

Fees raised in the month = £23,000 x 80% recovery rate = £18,375

Profit and loss account     

 

For month ending X

Month 1

£

Month 2

£

Month 3

£

Month 4

£

 

Fee income

18,375

18,375

18,375

18,375

 

WIP movement

0

0

0

0

(see balance sheet below)

Office rent

(3,000)

(3,000)

(3,000)

(3,000)

 

Salary cost

(4,000)

(4,000)

(4,000)

(4,000)

(PAYE/NI/Pension ignored)

Profit

11,375

11,375

11,375

11,375

 
      

Balance sheet

     

 

Work in progress

Month 1

£

Month 2

£

Month 3

£

Month 4

£

 

Brought forward

0

0

0

0

 

Time charged in month

23,000

23,000

23,000

23,000

 

Billed in month

(18,375)

(18,375)

(18,375)

(18,375)

 

Written off in month

(4,625)

(4,625)

(4,625)

(4,625)

 

Carried forward

0

0

0

0

 
      

Debtors

     

Brought forward

0

18,375

18,375

18,375

 

Billed in month

18,375

18,375

18,375

18,375

 

Received in the month

0

(18,375)

(18,375)

(18,375)

 

Carried forward

18,375

18,375

18,375

18,375

 
      

Cash at bank

     

Opening bank balance

30,000

23,000

34,375

45,750

 

Received - debtors

0

18,375

18,375

18,375

 

Paid – office rent

(3,000)

(3,000)

(3,000)

(3,000)

 

Paid – salary costs

(4,000)

(4,000)

(4,000)

(4,000)

 

Closing bank balance

23,000

34,375

45,750

57,125

 

Conclusion

The second example shows that the firm’s cashflow is significantly improved as a result of more regular billing and better payment terms.

Of course, these examples present a very simplistic view, but hopefully they illustrate how things can, and should, be integrated. Essentially replicating this for all employees and adding in other expenses should allow projection of the full cashflow for the firm for the coming months and years, thereby allowing the firm to base decisions on more accurate forecasts.

Andy Poolelegal sector partnerArmstrong Watson

Andy Poole is the legal sector partner at Armstrong Watson, specialising exclusively in advising law firms. Co-author of the Law Society toolkit on Financial Stability in Law Firms, Andy heads the legal sector team at Armstrong Watson, which has 15 offices and over 400 people. The legal sector team advises law firms throughout the UK on strategic, structural and other business improvement issues as well as providing efficient accounting, tax and SRA accounts rules services. 

The Law Society has exclusively endorsed Armstrong Watson for the provision of accountancy services to law firms throughout the whole of the North of England. 

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