Many law firms measure their own profitability by a simple net income to revenue percentage. Although an important statistic, this can miss important factors contributing to the profitability of your firm. For example, a firm with a high associate to partner ratio, may have a low income to revenue ratio due to associate compensation and other costs. Firms with a strong solicitor’s practice may require more staff, and would then have a higher overhead component than a litigator’s practice.
When reviewing a firm’s profitability, we usually focus our analysis on revenue, and review the following key areas:
Revenue on a Billing Basis
This is the most common method of measuring revenue. Most accounting programs produce internal statements on an “accrual basis”, or fees billed basis.
Revenue on a Production Basis
Many firms do not place very much importance on production and Work in Process (WIP). When reviewing your billings, if you have reduced your WIP from the beginning of the year, you may experience an increase in profit on a billings basis as a result of prior dated time billed in the current period. Your fee revenue may be less in subsequent years as a result. Similarly, an increase in WIP may reflect lower revenues until the time is billed out. Often accountants will produce financial statements with WIP revenue and WIP on the balance sheet. In this case, your financial statements are prepared on a “production basis”.
When your WIP is consistently climbing, you should review your billing system and cycles to ensure your fees are billed at an appropriate time.
Revenue on a Cash Basis
The flow of cash is critical in any organization. Law firms are unusual in that many firms collect fees after performing a service. An increase in accounts receivable suggests a firm should review their retainer and collection policy to facilitate client payments.
Most of a firm’s expenses will show in salaries and salary related expenses. A staff review to ensure you have adequate and skilled staff contributing towards production will confirm if you staff level is appropriate. Often, a firm can realize additional leverage by introducing a docketing initiative for the legal staff to gain some additional leverage from staff resources. Often your legal staff is providing value added services that is not being billed to clients.
Rent and other occupancy costs is often a distant second for costs. Make certain you are using your space effectively. If you are not using all your office space, plan to fill empty offices with producing associates. Another option can be to sublease empty offices to assist in deferring some of the rental costs.
All firms should prepare a revenue and expense budget for the upcoming fiscal year. This is a great opportunity to review all expense items and plan for spending for the coming year. Actual expenses should be compared to budget on a consistent basis.
A key performance indicator we use for measuring the profitability of your law firm is Net Income per Partner (NIPP). If you have non-equity, or income partners in your firm, you may want to exclude them from this exercise. If that is the case, then their compensation should be notionally added to the firm expenses.
Your NIPP will give you a good indication your profitability, especially if you compare the NIPP on a billings, production and cash basis. You may also want to review this figure as a percentage of partner billings, and NIPP in prior years.
Performing all of the above review and planning will indicate financial areas within your firm that requires attention and planning, and give you a better understanding of the financial health of your law firm.