Practice Tips, by Dave Bilinsky, Practice Management Advisor
Towards calm seas — the top 10 financial reports you need to stay on course
It has often been said that failing to plan is planning to fail. Yet many of us do not put time into planning our financial success before we set sail in our careers.
Financial planning is a matter of setting up our systems, getting a compass bearing on our goals, creating reports that measure our progress and modifying our performance as needed to stay on course. How do we assess how we are really doing? What reports should we be reviewing from our financial management systems? And what do they mean?
The key to starting out right is cash flow management - we must understand what money is coming into our practices, where money is flowing out and when all of this is happening. With our cash flow under control, we can then start planning other aspects of our financial future.
For the purpose of this analysis, I assume that you have already charted out an annual income and expense budget, broken down by month and reflecting all anticipated costs, including your monthly draw. Such a budget will show which months present the most dangerous financial reefs or shoals, so you can plan to steer clear. (A sample law firm budget is on the Law Society website in Excel format: see "Practice and Services/Practice Resources" at www.lawsociety.bc.ca.)
Here then are 10 monthly managerial reports you should be getting from your accounting system (and what they mean).
1. What are your overall and projected monthly billings? How are your overall monthly billings measuring up against the projected billings in your budget? This tells you if your gross income is meeting your projected cash flow billing needs. In setting your budget, consider what percentage of collected monthly billings you expect to take as a draw. According to one analyst, it should be 55-60%.1
2. What are your projected billings versus cash flow? Review your collected billings as measured against your budgeted cash flow needs for the month. This tells you if you are in a projected positive or negative cash balance for the month. Studies have indicated that you will have approximately a 105-day "lag" between the date you incur an expense and the day you collect that expense from your client.2 Accordingly, it is important to keep a handle on your potential cash deficit - for while you can cover a small short-term deficit, over the longer haul, your cash flow must be positive.
3. What are your actual versus budgeted costs? What are your actual costs as compared to your budget? This will tell you if you are managing to run your office within the financial constraints that you have anticipated. If your costs are higher than your budgeted amounts, you will be required to cut other costs or increase your collected billings to remain in balance.
To be on the safe side, look at cutting costs before trying to increase your income, as cost cuts take effect immediately, but income is subject to the collection "lag." However, over the long haul, cutting costs may degrade your ability to produce work and, thereby, to earn income.
4. What is your WIP? Do you record your time? If not, how can you ever determine if you have made a profit on any file - or if anyone else in the office has as well? Does your compensation system pay out draws and bonuses based on revenues (i.e. collections) or profits (i.e. the actual net amount to the firm after all costs including lawyer time)? If you are paying out on revenues, you are potentially paying bonuses to lawyers who have lost money to the firm on their files - thereby adding to your financial troubles.
The only way to determine this is to track all time (billed, unbilled and written-off) put into the files and include all this time as a cost of the file. You need to reconcile total revenues against costs (including allocated overhead and staff costs) to determine your net overall file profitability. Only then can you justify paying bonuses on truly profitable files.
Once you see the value of recording all lawyers' billable time, you have a further financial health question: "Is your work in progress increasing or decreasing?" If it is increasing, why? Is it due to time being put into contingency files that have the potential of paying off at some point in the future? Or is it building because you have not been billing as regularly as you should?
On files that can be billed monthly, you are doing yourself a disservice (and potentially digging yourself into a financial hole) if you fail to regularly bill for the work done. Here is a benchmark: WIP over 180 days/Total WIP = 20 to 40%.3
5. What are your unbilled disbursements? These represent credit that you have extended to your clients and therefore capital that is unavailable for you to operate your practice. If at all possible, bill these out to recapture the necessary operating cash for your office. Disbursements can be one of the biggest components of total firm debt, and can be a huge albatross around everyone's neck - particularly firms that have contingency files. A reminder: Total debt/net fixed assets = 50-80%.4
6. What are your receivables? Are they increasing or decreasing? What percentage are they of your annual billings? 15% is high, 5% is within the range of acceptability. Uncollectible accounts represent holes in the bottom of the financial boat - and will sink you if not plugged. If you do have an unpaid account, do something about it and quickly. You'll do well to remember that aging is beneficial only to cheese and wine.
Make early attempts at collection and determine whether or not further time and energy is warranted. Attempting to collect an unpaid account against an unhappy client often leads to professional conduct complaints and/or malpractice claims. These can be emotionally and financially draining as well as PR nightmares - even if they are resolved in your favour. By acting quickly and decisively and staying within your written client credit policy, you can minimize your exposure to bad debts.
7. What is your realization rate? The realization rate is the percentage of actual income paid to the firm from the billable hours of each timekeeper. For example, Partner X bills 200 hours per month at $200 per hour for a total amount billed of $40,000. Of that amount, 50 hours are written off or down (taken off the books) for various reasons, and clients pay a total of $30,000. Partner X's realization rate is 75%.
Partner Z bills 150 hours at $200 per month, but only 5% is written down or taken off the books, and her clients pay 95% of that for a total of $28,500. Partner X bills more hours but has a lower realization rate than Partner Z. Even with far fewer hours billed, Partner Z is generating almost as much income for the firm. Your computer-based time and billing program should be able to create this report for you. Examine the results and use it to help guide any discussion of compensation for partners and associates.
A low realization rate indicates that a lawyer is using resources of the firm inefficiently, which is usually a sign of poor client or file selection. Realization rates should be no lower than approximately 90-95%.5
8. What are your unbilled fees and disbursements by lawyer, client and area of law? Although some lawyers may not like it, firms should look at unbilled fees and disbursements aggregated separately by lawyer, client and area of law. Computerized accounting systems should be able to generate these aggregations for you. Look for trouble spots in these categories, and take steps to correct them as soon as possible.
9. What are your daily lawyer time summaries? Daily time summaries for lawyers are also important. To make this analysis accurate, all lawyers should be accounting for all their time - billable, firm administration or management, education, pro bono, vacation etc. Look for aberrations or time summaries that don't make sense or indicate poor time management or failure to meet minimum billable time requirements.
A quick way to determine how many hours you should be billing is as follows: Take your desired annual income (say $150,000). Collected billings should be approximately twice that - $300,000. Factor in bad debt at 10%. That indicates that you should be billing approximately $330,000/year. There are approximately 231 working days/year (365 minus: 21 days vacation, 104 weekend days, 9 statutory holidays). This indicates that you must bill just over $1,400/day ($330,000/231). If you bill at $250/hour, you must log 5.7 billable hours/day - every day.
By doing this analysis, you can determine if your desired annual income (or anyone else in your firm) has any reasonable resemblance to their daily work history.
10. What are your client trust account balances? Personally review the trust account balances for all clients monthly. Are there funds in trust that can be applied against unbilled time or disbursements? Can your accounting or practice management system produce a listing of the clients/files that are approaching the exhaustion of their retainers or funds in trust? Do you need to write to these clients and warn them that they need to bring in further funds and, if so, by what date? Is your written retainer agreement clear on the consequences of failing to replenish retainers?
These are just a sample of the financial reports that can be generated by most computerized accounting systems. It is important to understand the role that each one can play in running your practice and keeping your financial ship on course. Perhaps most importantly these reports will help draw your attention to small problems before they start rocking the boat.