Monitoring financial stability is an important aspect of the COFA’s role and one essential tool is having timely financial management information. This information not only helps with monitoring financial stability and performance, but also has many other benefits, such as providing the principals with informed information to enable them to make management decisions.
Most firms have good processes in place to manage financial information, but, surprisingly, we still find some practices operating with very limited financial information.
The size and structure of each practice will determine the level of detail in and the timing of management information: this will typically include management accounts, with a profit and loss account, balance sheet and a cash-flow statement. Overall, the information must benefit the individual law firm: what suits a large legal partnership is not going to be the same as what suits a sole practitioner.
Many case-management systems present the financial information on a cash basis, reflecting solely what has passed through the office bank accounts, with the exception of fees billed. This is different from a full accruals basis, which reports financial information when income is actually earned and expenses are actually incurred.
The accruals concept is important in a law firm, especially when accounting for unbilled time. Law firms will be familiar with the experience of having to recognise unbilled income in their annual accounts, in accordance with accounting standard changes. An example is moving from a cash basis to recognising unbilled income as work in progress (at the cost to the practice and, in more recent years, at the selling price) in accordance with FRS 5/UITF40 and now FRS102.
However, adjustments to unbilled income should not be left to the year-end accounts process. It is equally important to have a mechanism - which does not necessarily have to be complex – for recognising this income in the financial management information to give a more accurate assessment of profitability.
The accruals concept also applies to expenditure, where adjustments are required, in the form of prepayments and accruals, to match expenses with the time period to which they relate. Examples include annual professional indemnity insurance, paid in advance, and utility costs, invoiced in arrears.
When preparing the financial management information on an accruals basis, factoring in these areas can present a very different picture from that prepared on a cash basis.
Profit and loss account
In assessing profitability for the reported period, the profit and loss account is a good starting point, but it should not be limited to a simple review of the bottom-line net profit or loss. Examples of areas to review are:
- Fee-income performance, both in terms of fees issued and earned income levels. Is growth being achieved in line with the firm’s expectations and strategy?
- Expenses, so that anomalies, such as uncontrolled spending or an error in the information prepared, can be investigated.
- A comparison of the results with those from the same period in the previous year, so unexpected variances can be investigated.
- A comparison of the results with budgeted information, where available, so unexplained variances can be investigated.
Reviewing profitability does not have to be limited to the firm’s overall performance: it can be expanded, for example, to look at performance by teams, by office location or even by individual fee earners, to assess their gross contribution.
Expanding the profitability information can identify areas where decisions need to be concentrated: these may not be apparent from just looking at the performance of the firm as a whole.
Financial key performance indicators (KPIs) can also provide valuable financial information to compare the law firm’s performance and to benchmark against industry data.
Examples of profitability KPIs include:
- Gross and net profit margins.
- Profit per partner.
- Salary costs (including notional salaries for principals) as percentage of earned income.
- Fee income per fee earner and per partner.
- Other key costs as a percentage of fees, such as marketing, IT and property.
The balance sheet is a good indicator of the financial condition of the law firm at a given point in time.
Simple immediate indicators on the balance sheet to consider include the balance-sheet total and the current net asset or liability position. Both values are a measure of a firm’s solvency and, to demonstrate financial stability, a practice should look to ensure it can maintain healthy positions in net current assets and net assets total.
A firm’s lock-up is the level of cash tied up within debtors (office balances, i.e. costs billed and unbilled disbursements) and unbilled income. When using management information to review lock-up, a typical review examines the current assets, with particular reference to the office debtors and unbilled income values.
However, meaningful comparisons involve using KPIs, such as lock-up days in both office debtors and in unbilled income, and comparing these to, say, industry benchmark data. Although managing lock-up is a task in itself, it is vital for the successful operation of the law firm.
Preparing financial information to help with lock-up management can also include circulating reports to the fee earners for review and action. These can include items such as:
- Outstanding office balances, including both bills issued and unbilled disbursements
- Unbilled time reports, to assess billing and writing off non-recoverable amounts
- Exception reports, to show both client-specific office balances due and client funds held, which could be earmarked for the practice to transfer.
A cash-flow statement is a helpful financial document to reflect where a firm’s cash resources have been expended and where they might require additional monitoring and control.
The cash-flow statement can be expanded to report the total net debt position of the law firm: this can help monitor the debt gearing and financial stability of the practice.
A rolling cash-flow projection is a useful budgetary tool and report for managing cash as part of regular management information. This can help assess and manage daily cash inflow and outflow requirements. At times this can be a balancing act, when key payments fall due, such as VAT liabilities and income tax payments made on behalf of the principals.
This list is not exhaustive: the requirements for management information will vary between firms, but the list provides valuable considerations for all firms. The process of managing information could become even more important for law firms, once the government plans for Making Tax Digital come into force and the detailed reporting requirements become known. These will warrant another article in their own right!
First published in the Sep/Oct 2017 issue of Legal Abacus Magazine. COFA Corner is written by Jason Mitchell, Partner – Legal Sector Specialist at Francis Clark LLP
This publication is produced by Francis Clark LLP for information only and is not intended to constitute professional advice. Specific professional advice should be obtained before acting on any of the information contained herein. While Francis Clark LLP is confident of the accuracy of the information in this publication (as at the date of its production), no duty of care is assumed to any direct or indirect recipient of this publication and no liability is accepted for any omission or inaccuracy.