Rosy Rourke, legal sector director, Armstrong Watson, provides a full set of options for any law firm to improve its cash flow. The objective is to reduce any reliance on external borrowing or to remove the need for such borrowings entirely. (3 February 2022)
Cash flow management is always a key topic for law firms and has certainly been one of the main points of focus for firms during the pandemic. As we learn to live with Covid, it remains as relevant as ever. The ability of a law firm to access cash will secure its financial health and allow it to survive and grow.
Below are the ten main issues that law firms should consider when managing their cash flow.
Cash flow forecasts and projections can be prepared by law firms for specific reasons, for example:
- Raising finance
- PII applications
- Lexcel purposes
- Applications to the SRA on changes to their structure
However, more importantly, and as has been proven during the Covid-19 pandemic, they should also be used as a vital management tool for cash flow planning.
Any law firm, regardless of size, should be forecasting on two bases:
- A 13-week rolling cash flow forecast, to highlight any short-term cash pinch points which must be addressed immediately.
- Longer-term forecasts for at least 12 months ahead. These provide an indication of likely performance and let you assess any serious cash flow and financial stability issues, enabling better management decisions on matters such as recruitment and IT investment.
Cash flow problems can affect law firms of all sizes and even the most successful and profitable firms. Identifying potential pinch points in advance gives you a chance to sort out the problem. Forecasts also allow your firm to manage its fee-earners and to help them achieve their fee income targets as reflected in those forecasts.
The main cause of cash flow issues in law firms is the amount of cash that is tied up in lock-up (unpaid bills and work in progress (WIP)). Our legal sector benchmarking revealed that the current average number of lock-up days for firms of all sizes is 144 (August 2021), compared with 125 days a year previously. This key metric should be closely monitored.
Once you begin forecasting, you’ll notice that many of your firm’s costs are fixed, or are certainly predictable (recurring costs such as staff salaries, rent, subscriptions, etc).
What is far more difficult to accurately predict is your income and the timing of cash collection. But getting these forecasts wrong can potentially lead to insolvency and the firm’s collapse.
Using an Excel spreadsheet (or other software) you can make detailed forecasting models using your firm’s historical data to project your fee income. This data should include utilisation and recovery rates by individual fee-earner, taking into account seasonality, debtor days and WIP days by work type and department. This detailed approach lets you project your firm’s likely cash inflows and future financial performance based on known data.
This approach also allows for sensitivity analysis to be built into your forecasts. You can demonstrate the impact on the practice of best-case and worst-case scenarios, as well as highlighting what you need to achieve to ensure you have enough cash to continue as a business. These insights are invaluable for making timely and effective strategic decisions.
Monitoring your actual results against your projections then gives you a real understanding of the performance of your business. It enables you to keep things on track.
Use the projections as a management tool, to understand what you need to do to achieve your firm’s targets in the coming years. For example, the sensitivity analysis can be used to set utilisation and recovery targets for your team.
Preparing accurate projections will help you keep track of expected future profits and the impact that will have on your business and cash flow, either positive or negative.
The most common pinch points for cash flow in a law firm are when salaries, VAT and personal and corporation tax liabilities fall due. Salary and VAT liabilities are relatively easy to assess and forecast, but corporation tax, and in particular personal income tax liabilities, are more difficult.
Encourage your partners to complete their personal tax returns as soon as possible after the end of the tax year. These tax liabilities can then be incorporated into your forecasts.
Similarly, for larger limited company firms that pay their corporation tax in instalments, accurate forecasts can ensure accurate payments are made – matching profitability and cash flow.
Also, consider any partners’ retirement plans and the subsequent repayment of their capital accounts. How will this affect drawings levels for the next year? Individual needs must be balanced against the firm’s overall business needs.
2. Law firm financing options
If your firm’s cash flow requires an injection of funding, there are many financing options.
The firm’s bank is usually the first port of call, although the current high levels of debt in firms with bounce back loans and CBILs loans means that achieving further borrowings can be difficult.
One growing area of finance is litigation funding. This funding is provided directly to the client (or sometimes to the firm itself) by a third party, to pay fees and disbursements. Like invoice financing/factoring, this provides a cash inflow to the firm in the shorter term.
(It can also be used as a differentiator to win work for your firm, as it shifts the risk of failed litigation from the client onto the funder.)
Changes to your firm’s pricing strategy can dramatically improve your firm’s profitability and cash management.
Three simple ways to speed up cash collection are:
Payments on account
A payment on account can be taken from your client at the outset of the matter. This payment should not be used to pay interim bills, or it defeats the whole purpose of it - the client should pay the interim fees as they arise, and if they are not paid on time consider pausing work. When the matter does reach completion, a final bill can be sent to the client and the payment on account money transferred straight to the office account. This covers your own fees as well as disbursements.
Interim bills (where regulations allow) can be raised as often as reasonable and at least on a monthly basis.
Discount for payment in advance
Ensure that the client does in fact pay your discounted invoice in advance of you commencing the work. Otherwise, you should have recourse to charge them for the discount previously provided.
There are clear risks to the client if they pay for legal work which has not yet been done, or disbursements which have not yet been incurred. Those risks must be outlined to your client in advance so that they can make an informed decision, as required by the governing Standards and Regulations.
Billing in advance does not mean that it becomes the firm’s money. It is still client money and still needs to be safeguarded by you.
4. Credit control
Good credit control procedures help prevent late payment by clients and save time for everyone.
Ensure that your credit control policies and procedures are documented, so everyone in your firm knows what they should be doing. Your clients will then have the correct credit terms from the outset. The credit-control team will understand when to contact clients for payment, the method of contacting clients for payment, and also when work should stop or external debt collection should be used. The policy should empower your credit control team when dealing with both your clients and the fee-earners.
Use invoice and letter templates that include all the required information, preventing queries and delays.
Consider a credit check and scoring system for new clients. This can flag any issues at the outset, allowing you to consider payment on account options, or whether you want to engage with the client at all.
5. Cost controls
Many firms reviewed their spending during the pandemic and identified which of those costs were business critical, which costs could be scaled back when cash needed to be preserved, and which costs should have been cancelled long ago (eg unused subscriptions, ineffective advertising). The key is to ensure that that ‘un-necessary’ spending doesn’t start to increase once again.
- Asking suppliers to re-tender can lead to change, or simply to a re-set of the current relationships. It helps ensure that you are receiving the best value for money and services that you actually require.
- Suppliers may be willing to defer payment or offer a discount for a few months (or FOC) in order to keep your business and retain a long-term relationship.
- Where expenses are variable, such as utilities, you can explore moving to a fixed rate or an alternative tariff to help you with cash flow planning.
The final area to review is your cost control systems. Does spend in areas such as marketing or travel require approval or sign-off? Is that when the expense is over a certain amount, or for any spend? If justification and an outcome for the spend is required, is this monitored rather than simply being approved without question?
6. Obtaining credit from suppliers
Renegotiating credit terms with your suppliers is an additional option, especially if your firm is facing serious cash flow difficulties.
You could, for example, request a longer payment period, or a higher credit level overall.
Extended credit in a crisis
When a law firm is having cash flow difficulties and needs to make tough decisions on who or which suppliers not to pay, how do you do this?
The first port of call is often HMRC, who can offer time-to-pay arrangements (providing your compliance is up to date). Tax tends to be one of the largest outgoings for firms, so this can create some much needed breathing space.
Smaller local suppliers are usually put to the end of the list, as these businesses are often the most vulnerable. You need to protect your reputation in your community.
When you do request payment holidays or delayed payment terms, be upfront about your cash flow position. Honesty is the best policy so don’t agree to terms that you cannot meet. Work with your suppliers, landlords and finance providers to ensure all parties can achieve a positive outcome.
7. Charging for additional work
The statement ‘additional work charged for’ appears very simple and straightforward. If you were having a kitchen fitted and you asked for an additional partition wall to be installed, you would expect to pay the additional expenses for that, so why do professional services firms find scope creep so difficult to deal with?
If scope creep is identified, agreed and charged for, profitability and cash flow both improve with no extra work being performed.
Setting client expectations, by stating what is and isn’t included at the outset, is the key to dealing with scope creep. This issue is explained in useful detail in Richard Burcher’s article Pricing – a technology solution.
Many firms do not time record for fixed fee work; and even if they do, they do not necessarily monitor those records. The result is that additional work (and value) is sometimes provided to the client without it being charged for. If all fee-earners fully time record, management can analyse time spent and identify scope creep, enabling better decisions in the future.
8. Flexible workforce and outsourcing
In a downturn, inflexible overheads (eg office rents, staff salaries) can be disastrous in terms of profitability and cash flow.
But a lack of staff is a common issue at the moment, rather than a need to let staff go.
Nevertheless, many law firms have realised that they need to be far more agile. They want to be able to match their resources to the peaks and troughs in activity.
One solution is outsourcing. Most commonly, outsourcing occurs in the non-core activities such as FD services, cashiering, IT, HR and marketing. Either a full-time role is not required, or else the firm is seeking specialist skills (eg SEO and PPC skills for lead generation). Fee-earning staff are much less likely to be outsourced.
When recruiting staff, consider flexible contracts. Flexible options could make your firm more attractive to potential recruits, whilst also allowing you flexibility if the work to keep fee-earners busy full time is not always there.
9. Timing of when partner/bonus distributions are made
A common perception of partners’ drawings is that they are the equivalent of a monthly salary. They are not.
In most firms, partners’ drawings were the first outgoing to be reduced at the start of the pandemic.
At the time drawings were withheld, it was expected that it wouldn’t just be law firm cash flow that would be impacted, but also profitability. For equity partners this would mean that their annual profit share would be reduced, so it followed that their drawings should reduce to prevent over-drawing.
Fixed profit share partners are usually entitled to their fixed share (assuming overall profits allow). But even their drawings can be cut in order to preserve overall firm cash flow.
10. The danger of rapid growth and overtrading
What is 'overtrading'?
Overtrading occurs when a firm expands too quickly without having the financial resources in place to support that expansion. A law firm can start to overtrade when it has too many matters in progress at once. The average time for a matter to be completed (or simply to reach a billing point) becomes extended, so the cash inflows are delayed. Meanwhile the cash outgoings tend to increase (eg recruitment costs, VAT payments, and disbursements). Before you know it, the firm is struggling to pay its bills.
What are the warning signs?
The firm’s cash flow forecast should provide ample warning of any cash flow crisis caused by overtrading, provided the cash flow is up to date. Meanwhile, KPIs such as the number of matters in progress, utilisation rates, the lock-up period and the firm’s level of borrowings are all potential red flags.
Why is it an issue post-pandemic?
Pent-up demand or other short-term factors may mean that firms need to rapidly ramp up service volumes. Meanwhile, conscious of lost revenue either during the early Covid period or during subsequent troughs, some law firms will be keen to make up for lost revenues. So the monitoring of lock-up days and related KPIs will be key.
What lessons can we learn from firms that have got themselves into cash flow difficulties?
Often, the cause of the problem is overvalued WIP. The fee-earners may already know that much of the WIP will be irrecoverable, but they still leave the full amount in the revenue forecast.
The problem is then exacerbated if bills are sent out and the VAT is paid on these amounts when there is little chance of being paid.
The root cause of unpaid work is often that it was speculative in the first place. Perhaps the firm did not properly vet a new client, or took on a case with a low chance of success, or took on work that it was not properly qualified to deliver. Sometimes a firm (or a fee-earner) that is short of work will say yes to any enquiry that comes through the door. It is an accident waiting to happen.
The other side of the cash flow equation is expenditure, which some firms significantly underestimate. For example, a firm that budgets for PI costs to be the same as the previous year at a time when PI premiums for all firms are rising significantly.
Contingencies should be built in, especially in any period of change. So if you are hiring new employees, or implementing new software, or opening a new office, assume that something or other will probably not go according to plan. Costs may be higher, while the financial benefits may take much longer to realise than had been anticipated.
Cash flow management top ten
- Forecast and plan ahead.
- Invoice regularly.
- Provide a clear scope and fee quote.
- Implement clear credit control procedures.
- Routinely monitor KPIs.
- Take payments on account from clients where appropriate.
- Implement an easily accessible billing and payment system.
- Engage fee-earners in debtor collection.
- Negotiate payment terms with your suppliers.
- Consider financing options that are available.