Financial stability is making headlines: a string of big names have declared insolvency in recent months, many after issuing profit warnings. Andrew Otterburn provides a simple guide to measuring and monitoring your firm’s financial health

The Law Management Section’s 2018 Financial Benchmarking Survey indicates that median profit per partner has increased once again, from £152,000 last year to £162,000, this year – a rise of seven per cent. My work with firms across the UK bears this improvement out: most firms are doing pretty well.

The problem is that much of this profitability is driven by property; many firms, at least outside London, are extremely busy in residential conveyancing. For example, a firm I was with last month had opened 2,300 new residential conveyancing matters in the nine months to January 2018, compared with 2,100 in the nine months to January 2017 – a 13 per cent increase. Staff were under huge pressure, and they were trying to recruit an additional fee-earner. Most other areas of work had been flat or had declined.

Good times can often be tricky in law firms, as they can breed complacency among the partners. Big projects get pushed back, and issues that need tackling get delayed. Everyone is too busy to think about strategic issues – and who is to say the good times won’t continue? The problem is that markets invariably slow down, and there is every chance of a fall over the next year, as markets become spooked during the Brexit negotiations. Meanwhile, many firms are recruiting, and paying higher salaries, in order to get staff to do property work. A potential perfect storm.

Two other figures from this year’s Financial Benchmarking Survey also struck me.

  • Median capital per equity partner has increased by 17 per cent, to £228,000 – which is good.
  • 15 per cent of participants reported that drawings had exceeded profits in both 2017 and 2016 – which is not so good.

As all managing partners will know, we need profitability, but above all we need cash, and during any time of uncertainty, it is not good to be over-dependent on bank borrowing. All the banks look at particular metrics in assessing their law firm clients, and this article describes three of the more common ones that you may also like to calculate.

Ratio 1 – Borrowings : partner capital

This key ratio compares the capital the partners have invested in the firm with bank borrowings. The partners should have at least as much invested as the bank, ideally significantly more.

How do you calculate this?

You will need your year-end accounts produced by your accountants – this will show bank borrowing and also the partner capital invested in the firm. It may be split into current accounts and capital accounts – you should take the total.

Table 1 shows this calculation for a fictional firm with two partners (note: the indications in this article of what a bank might look for are based on one bank’s opinion – other banks might take a different view).

Table 1. Borrowings : partner capital (two-partner firm) 

 

 

 

 

Office account

 

-50,000

 

Bank loans

 

-75,000

 

Total (non-property) borrowings

 

-125,000

 

 

 

 

 

Partner capital

 

 

 

Partner 1

50,000

 

 

Partner 2 (newly appointed)

50,000

 

 

 

100,000

 

 

 

 

 

 

Ratio

 

125%

 

 

 

 

 

What might a bank want?

 

100% or less

The firm in table 1 has relatively little partner capital – as mentioned earlier, the median in the 2018 Financial Benchmarking Survey was £228,000 per partner – and less than the amount invested by the bank. The bank has more at risk than the partners. Over time, the partners would need to either increase the amount of partner capital in the firm or reduce their borrowings, or probably a combination of the two.

What action is needed?

If you have less capital invested than the bank, it is a cause for concern. You should always have more capital invested, so that in the event of a change in bank lending policy, you are not exposed. It will take time to change this – perhaps three years. You will need to pursue a combination of capital injection, reduced drawings, and better billing and cash collection.

Ratio 2 – Borrowings : Unfunded capital

The first ratio looked at borrowings shown on the balance sheet, but many firms, particularly most larger firms, have ‘off balance sheet’ borrowings, in the form of professional practice finance loans, and in some cases, these are substantial. Most partners appointed in the last 10 years are likely to have one such loan.

How do you calculate this?

The calculation is the same as shown in table 1, except you also need to take into account any professional practice finance loans the partners have. These are obviously not included in the firm’s balance sheet – you will have to ask each partner what the balance is.

This calculation will effectively give you the firm’s ‘unfunded’ or ‘free’ capital relative to borrowings – a figure of great interest to your bank.

Table 2 relates to the same example firm as table 1. One partner has been with the firm for many years and has over time built up her capital. A new partner was given a professional practice finance loan by the firm’s bank, to fund his capital of £50,000.

Table 2: Borrowings : unfunded capital (two-partner firm) 

 

 

 

 

Office account

 

-50,000

 

Bank loans

 

-75,000

 

Total (non-property) borrowings

 

-125,000

 

Professional practice finance loan

 

-50,000

 

Total borrowings

 

-175,000

 

 

 

 

 

Partner capital

 

 

 

Partner 1

50,000

 

 

Partner 2 (newly appointed)

50,000

 

 

 

100,000

 

 

Less professional practice finance loan

50,000

 

 

 

 

 

 

Unfunded capital

 

50,000

 

 

 

 

 

Ratio

 

350%

 

 

 

 

 

What might a bank want?

 

175% or less

The unfunded capital ratio will be difficult for most firms to change, at least in the short term, due to the scale of change needed, and the fact that these are long-term loans. However, your bank will be aware of this ratio, and this will influence its view of you.

What action is needed?

Most new partners have been given these loans in recent years, on an interest-only basis. These will often be younger partners in their 20s or 30s who will be unlikely to be easily able to replace them with their own capital. The problem with such loans is that they assume there will be an easy way for the partner to repay them on retirement, but that may not necessarily be the case. There could be much sense in partners repaying the capital over time, or at the very least making provision for its repayment. This may well require an adjustment in profit shares.

Ratio 3 – Profits : drawings (the ‘make and take’ ratio)

The two ratios discussed above concern the levels of borrowing relative to partner capital, and the main way this can be improved is often to leave more profit within the firm by reducing partner drawings. Ratio 3 compares drawings with profits. This is illustrated in tables 3 and 4, which relate to the example firm described above, and also show a larger firm with £10m turnover.

Table 3a. ‘Make and take’ ratio – accounts basis (two-partner firm)

 

 

 

£

 

 

 

Accounts basis

 

 

 

 

Fees

 

 

400,000

Opening work in progress/accrued income

 

-100,000

Closing work in progress/accrued income

 

150,000

Income

 

 

450,000

 

 

 

 

Staff salaries and overheads

 

 

317,500

Net profit per accounts

 

 

132,500

 

 

 

 

Monthly drawings

 

 

79,500

Partner income tax

 

 

53,000

Total drawings

 

 

132,500

 

 

 

 

‘Make and take’ ratio

 

 

100%

 

Table 3b. ‘Make and take’ ratio – accounts basis (firm with £10m turnover)

 

 

 

£

 

 

 

Accounts basis

 

 

 

 

Fees

 

 

10,500,000

Opening work in progress / accrued income

 

-2,000,000

Closing work in progress / accrued income

 

2,500,000

Income

 

 

11,000,000

 

 

 

 

Staff salaries and overheads

 

 

8,000,000

Net profit per accounts

 

 

3,000,000

 

 

 

 

Monthly drawings

 

 

1,800,000

Partner income tax

 

 

1,200,000

Total drawings

 

 

3,000,000

 

 

 

 

‘Make and take’ ratio

 

 

100%

How do you calculate this?

Simply take the profits available for the partners as shown in the accounts, and compare this to total drawings in the accounts. This will comprise monthly drawings and payments of income tax.

The calculations for both firms appear to indicate all is well: drawings do not exceed the profits being generated.

This ratio is a useful starting point, but ‘profit’ is not the same as cash. Because a firm’s cash position is affected by changes in debtors and work in progress, the profits shown in a firm’s accounts may be very different to the cash in the bank.

In the larger firm, the apparent profits shown in the accounts are £3m, but part of these profits (£0.5m) is due to an increase in work in progress. This means that the ‘cash profit’ actually available for the partners to draw is £2.5m. Debtors have also increased by £0.5m, so the actual cash generated in the year is just £2m.

The position of the two-partner firm is also bad. Profits as shown in the accounts are £132,000, but £50,000 of this relates to an increase in work-in-progress, which may take months to be translated into cash in the bank. Fortunately, there has been no change in opening and closing debtors. Tables 4a and 4b show the cash position.

How do you calculate the cash basis?

To calculate the ‘cash’ profit, take the profits figure as shown in the accounts, and adjust it for any increase / decrease in work in progress. If debtors have changed significantly, you should include that movement as well, as that also affects the cash available.

Table 4a. ‘Make and take’ ratio – cash basis (two-partner firm)

 

 

£

£

 

 

Accounts basis

Cash basis

 

 

 

 

Fees

 

400,000

400,000

Opening work in progress /accrued income

-100,000

-100,000

Closing work in progress /accrued income

150,000

150,000

Income

 

450,000

450,000

 

 

 

 

Staff salaries and overheads

 

317,500

317,500

Net profit per accounts

 

132,500

132,500

 

 

 

 

Adjust for WIP movement (paper profit)

 

-50,000

 

 

 

 

Cash profit

 

 

82,500

 

 

 

 

Change in debtors

 

 

-           

Cash available

 

 

82,500

 

 

 

 

Monthly drawings

 

79,500

79,500

Partner income tax

 

53,000

53,000

Total drawings

 

132,500

132,500

 

 

 

 

“Make & Take” ratio

 

100%

161%

Table 4b. “make & Take” ratio - cash basis - (firm with £10m turnover)

 

 

 

 

 

 

£

£

 

 

Accounts basis

Cash basis

 

 

 

 

Fees

 

10,500,000

10,500,000

Opening work in progress /accrued income

-2,000,000

-2,000,000

Closing work in progress /accrued income

2,500,000

2,500,000

Income

 

11,000,000

11,000,000

 

 

 

 

Staff salaries and overheads

 

8,000,000

8,000,000

Net profit per accounts

 

3,000,000

3,000,000

 

 

 

 

Adjust for WIP movement (paper profit)

 

-500,000

 

 

 

 

Cash profit

 

 

2,500,000

 

 

 

 

Change in debtors

 

 

-500,000

Cash available

 

 

2,000,000

 

 

 

 

Monthly drawings

 

1,800,000

1,800,000

Partner income tax

 

1,200,000

1,200,000

Total drawings

 

3,000,000

3,000,000

 

 

 

 

‘Make and take’ ratio

 

100%

150%

What action is needed?

Unless the firm has substantial cash balances, or bank agreement has been obtained, drawings should not exceed cash available, so this ratio should always be less than 100 per cent. If the firm has to fund any loan repayments, the drawings need to take account of this.

Because the accounts profit takes account of changes in work in progress, the apparent profit might not actually be available to take – it is a paper profit, and may take several months to actually be translated into cash. Drawings should therefore be constrained to the actual cash likely to be available. This is often a difficult figure to predict, but as a rule of thumb, drawings might be restricted to 75 per cent of profits. This also leaves some headroom for funding working capital.