Practice Tips: Black or red? How to tell what’s really profitable in your practice
by David J. Bilinsky, Practice Management Advisor
An objective of every law practice is to provide legal services while returning a reasonable profit to the lawyers for their efforts on behalf of clients. After all, if we aren’t making a profit, the doors won’t remain open for long.
In this column I thought I would return to basics and discuss the typical financial reports that you could be generating from your accounting system and why they are important. In particular, I will highlight some of the differences between the cash basis of accounting and the accrual basis of accounting. The idea is to provide you with greater insight into the operation of your practice. By concentrating on the indicators of financial health, you really can put more green in your jeans, without working harder.
This document, typically prepared annually, shows a snapshot of the assets, liabilities and equity in your practice at a certain point in time. For our purposes in looking at the finances of a law firm, its principal use would be to determine the relationship between assets and liabilities. Simply put, assets should be greater than liabilities. Bankers will also see if the owners of the practice have placed enough of their own capital at risk in the practice by looking at the relationship between liabilities (principally debt) and owner’s equity. However, as an indicator of financial health, that is of limited purposes to us.
This is a measure of the revenues (or topline metric) generated by your practice over a certain time period (typically monthly or annually), offset by expenses incurred over the same period. While the income statement can show the profitability of a practice over a time period, it also may produce distorted results if there is a difference in timing between the incurring of expenses relative to the receipt of revenues. For example, the monthly income statement of a firm handling contingency fee work may show completely different results depending on whether the income statement is dated the month before a big contingency fee award (where you have incurred high expenses but little revenue) or the month after the award (when you have received high revenues but few expenses).
Related to this measure is calculating the right percentage of a lawyer’s income relative to collected monthly or annual billings. The typical benchmark is 55-60%.
Statement of cash flows (or source and application of funds)
This statement takes your beginning cash balance for the period (typically a month), adds in all revenues received, deducts all expenses paid and arrives at the closing cash balance for the month. If you are using an accrual accounting system (and virtually all Canadian law firms do so), the Source and Application of Funds Statement is a necessity to bring everything back to cash.
The reason is the accrual system recognizes revenues when the invoice is rendered (not paid) and it spreads out certain expenses (called depreciation) over the lifetime of an asset, notwithstanding that the expenses must be paid in one accounting period. The accrual system can be very useful for looking at your practice over a long period, but the Statement of Cash Flows (and other financial reports) are needed to keep a handle on that all-important financial asset, namely cash!
There are two principal reasons for preparing a budget. The first is to forecast your expected revenues and expenses for a certain period (typically one year). The second is to compare your forecast numbers against your actuals (typically monthly and year-to-date), in order to determine if you are managing your practice within your expectations. Your income statement and budget comparisons will often be your first indications of future trouble and should be looked at monthly, if not more often. Your labour costs (including your draws), rent and technology expenses should account for approximately 85% of your budget. There is little that you can cut if times turn downwards without seriously impairing your ability to get work done — meaning that monitoring your budget is especially important as funds grow scarce.
Your budget should contain a calculation of your HEAR — the highest expected annual revenue, based on total expected billable hours for each lawyer per year. There are approximately 231 working days/year: 365 minus 21 days vacation, 104 weekend days and nine statutory holidays. The expected annual billable hours can range from 1,386 billable hours/year (231 work days/year x 6 billable hours/day) to 2,310 billable hours/year (231 days x 10 billable hours/day).
Every lawyer should have a standard hourly rate. That is so, even if you are a contingency fee biller. A standard hourly rate provides a baseline measure that is used in other financial calculations, principally to determine profitability. Now if you multiply your standard hourly rate by your billable hourly expectation, you arrive at your HEAR. This should be part of a firm’s budget for each lawyer.
If your standard hourly rate is $250 an hour and you expect to bill 1,700 hours a year, your HEAR is $1,700 x $250 = $425,000.
Daily time summaries
Daily time summaries by lawyer are also important. To make this analysis accurate, all lawyers should be accounting for all their time — billable, firm administration, education, pro bono and vacation. 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% (this is a little higher than normal but we are building in a bit of wriggle room for safety). That indicates that you should be billing approximately $330,000/year. There are approx 231 working days/year (365 minus: 21 days vacation, 104 weekend days, 9 statutory holidays). This indicates that you must bill approximately $1,400/day ($330,000/231). If you bill at $250/hour, this indicates that you must log 5.6 billable/hours/day — every workday.
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 of $40,000. Of that amount, 10 hours are written 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 has no “write downs,” and clients pay 95% of that for a total of $28,500. Although Partner X bills more hours, because of Partner X’s low realization rate, Partner Z with far fewer hours billed 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 90%, and 95% is your target rate.
Write-up, write-down report
The purpose of this report is to show the variance between your actual fees billed on each file over a certain time period measured against a standard measure, being your standard hourly rate times your billable hours logged on each file. This comparison provides an indication of which files, clients or lawyers produce high write-ups (for example on contingency fee work) or high write-downs. The typical benchmark is that an hourly rate biller should have, on average, a 5% write-down rate (in other words, a 95% collection rate) and a contingency fee biller should have, on average, a 150% write-up rate. If you are under either of these, then the write-up, write-down report will draw this to your attention and allow you to take corrective action, typically by tighter client/file acceptance policies and retainer requirements.
Client activity reports
There are any number of reports that can be run for each client. The typical reports are:
- fees billed
- effective hourly rate (EHR)
- accounts receivable
- fees collected
- trust balances
- work-in-progress (WIP)
- outstanding disbursements.
Fees billed are simply a volume indicator that allow you to rank clients on their ability to generate high-fees to low (a top-line metric). Unfortunately many firms do not look much beyond fees collected (i.e., revenues) and the amount of cash in the bank account as their principal financial indicators. There is much more that they can and should be looking at if they wish to increase the profitability of their practice.
EHR(Effective Hourly Rate): This results from dividing fees collected by client by the hours logged in the file (total hours, not just hours billed). If you then sort your clients by high EHR to low, you can start to dig a bit deeper and rank the relative profitability of your clients from high to low.
For example, assume you have two clients, each of which you billed $10,000. Their top-line metric (revenue) is the same. Now assume for client A you logged 100 billable hours and for client B you logged 500 hours. Client A’s EHR is $10,000/100 = $100/hour while Client B’s EHR is $10,000/500 = $20/hour. You don’t know the absolute profitability of either client A or B, but in relative terms, you can clearly see that client A is much more profitable than client B. If you don’t log billable time, then you have no basis on which to start to determine even the relative profitability of any client, much less the absolute profitability.
Accounts receivable: There will always be clients who pay their invoices shortly after the date of receipt and others that will drag out payments for 90 days or longer. By date-aging your receivables (over 90, over 60, over 30, current) and ordering them highest-to-lowest in each date range, you can again see who is costing you money (since you are in effect carrying the financing costs of unpaid fees and disbursements). Accounts receivable should turn over every 60-80 days — anything older than this should be dealt with pronto — as aging enhances only cheese and wine.
Recall that while your accounts receivable extend out over 90 days, your accounts payable demand payment in 30, leaving you with a time lag or delay. In fact, there is typically a 105-day delay on average between rendering an invoice and receiving payment. Accordingly, since that is about three “paying” periods from an A/R standpoint, monitoring you're a/P becomes an exercise in cash management. This also indicates how a growing firm can actually dig itself into financial trouble since increased expenses are incurred now (and must be paid within 30 days), but increased revenues will not be recognized for 105 days or longer. This indicates that the firm will be subject to a cash-flow squeeze as a result of their growth, and this must be covered for the firm to survive.
If your collected annual receivables are increasing each year, you’ll want to know how much of the increase is coming from an increase in your hourly rates and how much of it is the result of an actual increase in the amount of business you are handling.
To make these calculations, you will need to gather your collected revenue, your average billing rate and your number of hours billed for the two periods you want to compare. Let’s assume that in 2004 you collected $350,000 in gross revenue, your average hourly rate was $150, and you billed 1,500 hours. In 2005 you collected $400,000 in gross revenue, your average hourly rate was $175 and you increased your billed hours to 1,600. To determine how much of the revenue increase resulted from additional business (and not the increase in average hourly rates) you’ll have to do the following:
100 [increase in billable hours] x $150 [last year’s average rate] = $15,000 ÷ $50,000 [total revenue increase] = 30%.
In this example, 30% of the revenue increase was the result of additional business while 70% resulted from the increase in the lawyer’s average billing rate. Obviously, you want these numbers to be the other way around. A firm can only increase revenue by raising rates for so long; after that, you’ll have to increase the amount of new business you handle if you want to keep increasing revenues.
Fees collected: If you aggregate the legal fees by client, ranked from largest to smallest, you can determine which clients contribute large amounts towards your total fee billings. If you aggregate these numbers over a year and divide your client billings by your total annual billings, you can determine the percentage that each client contributes towards your annual fee billings. That is, assume you billed a client $25,000 last year. Your total billings were $300,000. That client contributed 8.3% of your annual fees ($25,000 / $350,000 X 100%).
Trust balances: This isn’t so much a profitability measure as a determination of which clients use large amounts of your accounting resources. An interesting correlation is to see how many of these clients are also high fee generators, or not, as the case may be.
WIP: This is your banked inventory. The problem is, it doesn’t produce any results sitting in inventory. A useful metric is the number of days that WIP sits in inventory before it is billed. Do a printout from your accounting system that lists the amount of WIP per file along with the days that it has been in inventory. WIP should turn over every 60-70 days. If you have large amounts that are sitting there approaching 60 days (or longer), then it may be time to consider billing them and converting them to accounts receivable.
To see where you stand, divide your WIP older than 180 days by your total WIP and multiply by 100 to obtain a percentage. If the result is 30% or less, you’re in relatively good shape. If the result is 40% or more, consider foregoing new matters until you can make time to bill for the work that you have already done. No WIP over 90 days? Then you’re in great shape!
Outstanding disbursements: Clients who generate large disbursements use a disproportionate amount of the firm’s capital, particularly if the disbursements are carried by the firm for any period of time. By ranking outstanding disbursements by client from largest to smallest, you can see the relative ranking of clients in this regard. An interesting question is to ask yourself if clients with high outstanding disbursements can be carried.
Projected billings versus cash flow report
Recall that billings, on average, are outstanding 105 days prior to payment. If you have large upcoming cash requirements (practice insurance payments, bonuses, income tax) then to avoid having to call on your line-of-credit to meet these needs, you need to bill an adequate amount well in advance of the cash requirement date to ensure that the funds are in hand. Accordingly, your projected billings versus cash flow report allow you to anticipate if you are going to be in a cash plus or negative situation and take remedial action if necessary.
Unbilled fees and disbursements
All of us have to bank fees until such time as they can be billed. The average time of carrying unbilled fees is between 60-70 days. Disbursements are usually carried for 60-80 days. If you list your unbilled fees by date, oldest to most recent, as well as unbilled disbursements, you can determine which clients or files are being carried for an inordinate time prior to billing and which are not. Large unbilled fees or disbursements can be a warning sign of procrastination, it can be a warning sign of a problem client, and it most definitely is a warning sign of future difficulty in collection. By monitoring these two classes and preventing them from exceeding a certain amount over a certain date range, you can minimize your exposure to large (negative) impacts on your cash flow.
These reports determine the “leakage” or lost income resulting from time leakage — from failure to record billable time, to writing off time at the moment of billing, writing off time at the time of collection or writing off the account in its entirety. Last, there is the leakage resulting from carrying unpaid disbursements from time of billing to payment. By comparing your HEAR (your standard hourly rate x your annual billable hour target) to your actual annual fee receipts, you can see the total amount of your billable time leakage. By determining the time written off, your uncollected time and estimating the unrecorded time, you can arrive at the totals for each type of leak — and then take steps to stop up these leaks. It’s essential to keeping your financial boat afloat.
You can immerse yourself in detailed reports, or you can instruct your bookkeeper to produce reports that only provide the exceptions (i.e., unpaid fees or disbursements over a certain dollar threshold and past a certain date). This way, you keep your eye on the forest, not only the trees, and focus on the matters most important to you.
It can be a very detailed process to determine actual overhead rates to apply to fee billers and can be quite time-consuming. However, you can do a quick and dirty overhead calculation to determine overhead rates.
If you are a solo lawyer, simply divide your annual expenses by your actual annual billable hour expectation. This will provide you with an approximate cost-per-hour or standard cost to render professional services. If, on any file, you are not collecting at least your billable hour total x your standard cost, you are losing money on that file.
An example will help.
Assume you expect $100,000 in draws from your practice. You pay your secretary $45,000 (including salary and all benefits). All other overhead expenses total $25,000 for the year. Your total expenses are $100,000 + $45,000 + $25,000 = $170,000. Assume that you bill 1,700 hours/year. Your standard cost of rendering services would be $170,000 / 1,700 = $100/hour. If you are not collecting at least $100 for each hour you put into a file, then that file is simply costing you money.
If your firm is composed of multiple timekeepers, you will need to factor out each person’s overhead rates or decide to treat all equally, at least in terms of overhead rates. However you decide to do this, having some idea of standard cost amounts will allow you to start to determine absolute profitability of clients, files, lawyers and practice groups.
In the end result
As you can see, law firms can quickly progress beyond looking at revenues, to looking at relative profitability factors, to doing a profitability analysis. Profitability reports mean no more muddled guesswork. Finally, the black can be distinguished from the red, and everyone affected by the bottom line know what it is. At that point, financial decisions — and yes, this includes fee-biller compensation, draws and bonuses — can be made with much greater confidence.