Practice Tips: Six steps to improve your practice profitability
by David J. Bilinsky and Laura Calloway
There’s no getting around it if you’re a sole practitioner or a member of a small firm: You have to do the math. Larger firms often have full-time administrators, and megafirms have stables of financial pros to keep tabs on their business matters. As a small firm lawyer, you’re the one who has to start crunching the numbers and making changes if you hope to improve your bottom line. But what numbers should you be looking at? What things should you change? Here are six steps you can take to better understand — and improve — your practice’s profitability.
One: create a business plan
As Yogi Berra said, “You’ve got to be very careful if you don’t know where you’re going, because you might not get there.” Ergo, you need a business plan.
A business plan is your road map to the financial future. You can show it to banks, suppliers or others you will need to deal with to demonstrate that you’ve done the homework necessary to launch your practice or to move forward to the next level. A sound business plan is an organized explanation of where you plan to go and how you intend to get there. All successful businesses are planned on paper well before the doors actually open, but even if you’ve already been in business for many years, it’s not too late to sit down and draw up a business plan. And it’s a great way to refocus and revitalize a practice that has lost its way over the years and is wandering in the wilderness.
A business plan can be as simple or as detailed as you wish, but it always needs to contain four essential elements:
1. A general description of your business, including the services you intend to provide and the markets you intend to serve;
2. Your financial plan, including a budget detailing anticipated revenues and expenses;
3. Your management plan, with a description of how you will set up your office and support the delivery of your legal services;
4. Your marketing plan (think client development), showing how you intend to keep existing clients and reach new ones.
Be as precise as possible when drafting the financial part of your plan, including your budget. The care and forethought you put into correctly anticipating future income and expenses can spell the difference between success and failure for your practice.
You should prepare a detailed, month-by-month budget for at least the initial 12-month period. Include all known or anticipated expenses, and when they will come due. Factor in an additional amount for unexpected expenses (anywhere from 10 to 20 percent is a safe bet), since it is Murphy’s Law that costs will always be greater than you expect, particularly as the volume of work increases. Build in marketing time and expenses as well, and don’t forget to include your draw. After all, if you don’t look after yourself, no one else will.
If you already have an earnings track record, look back for historical data to spot trends and seasonal fluctuations. If you’re just starting out, you can still make an educated estimate based on your marketing plan. Use a conservative estimate of how much business you will initially attract. Then, compare your estimated income and outgo on a month-by-month basis. If you show negative cash flow for several months in a row, will you still have the funds on hand to meet your needs? If not, where will the funds come from?
Once you’ve set out well-defined income and expense targets, you will be able to judge for yourself whether you’re meeting, exceeding or falling behind your goals. Review the goals you’ve set on an ongoing and regular basis. If you find yourself failing to hit your target, take corrective action by cutting unnecessary expenses and thinking strategically about potential new business — before it’s too late. If you ignore the initial signs of trouble, you may find that you are quickly out of business — and possibly facing even greater debts than when you started.
Two: implement a financial reporting system
After developing your business plan, you need to implement a system that can deliver financial information — in the form of sufficiently detailed and timely reports — necessary to determine whether you are meeting your business targets. At a minimum, these reports should include the following:
- a statement comparing actual income and expense numbers against your budget, for both the current month and the year to date;
- a statement showing worked but unbilled hours (WIP) for every lawyer, for both the current month and the year to date. It should also compare the actual WIP against the expected level of WIP;
- a statement showing actual billings by lawyer for the current month and the year to date. It should also show the expected level of billings and whether each lawyer is above or below expectations;
- a statement showing collections by lawyer for the current month and the year to date. It should also show write-offs and write-downs and compare actual collections against budgetted amounts;
- a statement showing aged accounts receivable by lawyer, by client and by area of practice;
- a statement showing unbilled disbursements by file and comparing them to the previous month to show whether they are increasing or decreasing;
- a statement showing funds in trust by client and whether those funds are retainers or funds held on behalf of clients;
- a statement of upcoming trials and motions that compares the expense and retainer funds in trust for each client against expected costs and fees for the courtroom work.
Three: scrutinize your cash flow
Although accountants encourage accrual-basis bookkeeping as a way to examine whether billable hours are finding their way to the bottom line, in the real world your firm will still live or die by its cash flow. Accordingly, your accounting system has to forecast cash flow needs and compare them with expected cash inflows. Any excess cash can be returned to the lawyers as bonuses or reinvested in the practice. Any cash shortages must be covered either by the lawyers (by way of lowered draws or capital contributions) or by increasing the firm’s debt (usually by increasing the line of credit).
While occasional short-term cash shortages can usually be covered, long-term chronic cash deficits usually herald the undoing of a firm. Simply increasing firm WIP can drive you to ruin unless you are also converting that WIP to cash. A law firm’s objective is not just to perform legal work, but to change that intellectual effort into cash. A cash flow statement ensures that this is being done at a rate sufficient to keep the business afloat.
One cash flow item many lawyers fail to monitor and anticipate is taxes. Whether it’s monthly withholding taxes for your employees or quarterly self-employment withholdings for yourself, these items come around regularly. They need to be a part of your routine, budgetted expenses, with the money to pay them regularly set aside before other distributions are made.
Amounts to be remitted to the government — whether they are collected taxes or employee withholdings — are deemed to be trust funds, and failure to pay those charges in a timely manner will result in dire consequences.
Four: track your time
Many lawyers do not track their time. They give various reasons, the three most common being: “I only handle matters on a contingency basis, so the hours I put in don’t really matter,” or “Tracking billable hours just takes away from the time that I can be doing legal work for clients,” or “All that really counts around here is the amount of money that you bring in every month, not the number of hours you work.”
What these lawyers are really saying is, “Keeping up with my hours is a bother, and I can’t be bothered!” They are obviously missing the point if they want to improve their individual financial performance. For the individual lawyer, financial performance really comes down to two measures:
1. effective hourly rate (EHR)
2. total billings.
You determine your effective hourly rate on a file by taking your fees billed and dividing them by the total hours put into a client’s file (not just the hours billed but all the time worked, whether billed or not). When you measure the EHR for all your files and rank the results from largest to smallest, you can see which clients and files generate high dollars for the effort involved and which are low contributors. This is a quality indicator — telling you which cases and clients result in high returns and what type of cases and clients you should be seeking to acquire.
After you’ve determined your EHR, calculate total collections per lawyer, per file, per month. This is a quantity indicator, and the usual metric used by lawyers. When you look at total collections, you have an indication of which files generate large bottom-line results.
Now — to work smarter and not harder — concentrate on clients and case types that are at the top of the list for both EHR and total collections.
Five: reduce steps and increase work flow
Look to automation to increase your efficiencies. There are many software products and technological gadgets available for legal professionals. As an example, one of the most fruitful products for enhancing work flow is practice management software (such as Amicus Attorney, Time Matters, PCLaw, ProLaw and PracticeMaster). However, just having the software doesn’t necessarily boost the bottom line. You need to integrate the products with your office procedures, and with each other, to reduce costs and increase efficiencies.
One obvious way to increase your work flow is to integrate your accounting system with your practice management application. Many small firms still don’t have automated time and billing systems or, if they do use software, they use one product for timekeeping, a second for contacts maintenance and a third, unrelated, product for calendaring and docketing. Often these products are on separate computers that aren’t linked through an office network and, consequently, can’t share information. A secretary or the lawyer must enter a new client’s data in the contact management software, then pass the intake sheet or paper file over to the bookkeeper, who has to re-enter the same information into the billing program on another computer.
Think of the savings in time and effort if that information can be entered — and updated — by one person, in one place, and everyone in the office can share it. Plus, integrating your accounting system with your practice management software will also allow you to post your time and billing data directly into your accounting system from your computer as you work — doing away with paper timesheets.
If you’re not sure whether the purchase of a particular program can help your bottom line, you can evaluate your expected benefits from the technology by doing a return on investment (ROI) analysis. To illustrate, here is how you can quantify some of the efficiency gains that you can realize from the implementation of case management software.
ROI analysis in action. Most firms employ at least a part-time bookkeeper to do time postings. For this example, let’s assume that time and billing entries take 40 percent of the bookkeeper’s time; that he or she is paid $35 per hour, including benefits; and that he or she comes in two days per week. You’re thinking about purchasing a case management system and integrating it with your accounting system, but at $5,000 the price seems steep and you don’t know whether it would be a cost-effective move.
Your savings by implementing this aspect of practice management would be:
8 hours x 2 days x 40% x $35 x 52 (weeks) = $11,648
Your ROI would be:
($11,648[savings] - $5,000[cost]) ¸ $5,000[cost] = 133%
Looked at another way, you would recoup the program cost in approximately nine weeks, considering just the savings in bookkeeper costs. (Of course, this analysis assumes that you cut back on your bookkeeper’s hours as a result!)
In addition, case management applications allow you to link together all communications on a particular matter, whether they be word processing documents, telephone notes or emails sent or received, and to group them all in one place. Add a scanner to turn hardcopy pleadings and correspondence you receive into digital form, and you can set up a virtual file for each matter you’re working on. Then, when you receive a phone call from the client or opposing counsel, you don’t have to scramble around looking for the file. You just click on the client name, select the matter and view any document or other information you need.
Let’s assume that you spend an average of a half hour each day leaving your office to look for files or documents in order to return phone calls. Let’s also assume that this half hour is not “billable,” since you aren’t actually doing any productive work for your clients during these searches. What is your ROI if you could save this wasted time?
If your billable hourly rate is $100 per hour and you work an average of 231 billable days each year, your increased billable time is:
.5 hour x $100 x 231 days = $11,500
That’s your savings per year just by avoiding the search for files! Even if implementing the practice management product requires your firm to incur hardware, software and training costs of $5,000 per timekeeper (for computer upgrades, network upgrades, software purchases and the like), your payback period on the cost would be:
$5,000[cost] ¸ $11,500[savings] x 365 days = 159 days per timekeeper (less than six months) to recover your monetary investment
As you can see, sole practitioners and small firms can realize a substantial return on investment by taking advantage of improvements in work flow.
Six: reward the behaviour you want to encourage
Scientists have long known that the subjects of experiments, whether they be lab rats or lawyers, repeat behaviour that is rewarded and avoid that which is not. Accordingly, if you want your firm to move toward certain goals, you need to make sure that your compensation system is designed in a way that rewards the behaviours that will help you reach those goals, and discourages activities that are counterproductive.
Law firm compensation systems, whether intentionally or unintentionally, generally reward one or more of the following:
- production of work
- referring clients within the firm
- superior client service
- effective delegation of work
- meeting or exceeding budgetted revenues
- meeting or falling below budgetted expenses
- mentoring, managing and supervising associates and staff
- firm leadership and business planning
- capital investment, ownership and risk
- participating in community, bar association and pro bono activities.
Regardless of how you decide to divide the pie, look at your stated business goals, and then check whether your compensation system promotes those goals or actually encourages the firm’s lawyers to disregard, or actively work against, them. For example, what if you are trying to encourage your firm’s lawyers to refer more business within the firm, but each lawyer is paid based solely on the number of hours he or she bills? You won’t see many clients being referred. There’s absolutely no incentive to remove the nose from the grindstone to engage in cross-marketing activities.
Share the numbers and increase the sum
Improving the bottom line isn’t just a result of working harder. There are ways to increase the cash in your pocket that do not involve more billable hours. However, they do involve looking at your practice — including the numbers that underlie it and seeing what those numbers reveal.
Once you know and understand the financial underpinnings of your practice, you can start pulling levers that connect to profitability factors, resulting in an increase in net income. And once you can demonstrate the greater cash flow that will result from your proposed changes, other firm lawyers as well as staff can see what’s in it for them too.