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Many years ago in law school I took a class on law firm management. I remember very little about the class other than it was drilled into us that unless we kept accurate billing records,
we had no hope of ever being paid. The lesson I learned was that if you keep time records and send out monthly statements, the money will soon flow in. It didn't take long in practice to
discover that there is a little bit more to running a financially successful law practice than simply keeping records and sending out bills.
This article is not about how to collect from slow paying clients, nor is it about how to invest the fruits of your labors, nor how to manage your 401(k). What this article does try to do
is explain how managing cash flow can help you sleep better at night, and give some tips on how to improve cash flow.
How to Go Broke While Making a Profit
Before beginning, we have to lay some foundation for the non-accountant types. First is the concept of accrual basis accounting. Most
businesses, and banks, especially, use accrual basis accounting. Accrual basis means that once you have done everything necessary to earn a fee, that fee is booked as income, whether or
not you have actually received the cash. Similarly, when an obligation is incurred, it is booked as an expense, whether or not you actually have written the check. Contrasted to this is
cash basis accounting, which says that income isn't recognized until it is received, and expenses aren't incurred until they are paid. As an example, assume your firm uses accrual basis
accounting. You have completed a matter for a client and sent a bill for $2,500 on July 1. For the month of July, you would show that $2,500 as income, even though you may not receive it
for some time (or never). Similarly, suppose in July you purchased supplies on account for $1,000. That $1,000 becomes an expense for July even though you may not actually pay it until
August or later. If you use cash basis accounting, you would not book the $2,500 fee until it was actually received, nor would the expense for supplies be incurred until it was paid.
You can see that the choice of accounting methods has a substantial impact on a firm's income statement. In fact, it is possible to go broke while making a profit! Here's how.
Consider the firm of Bass, Walleye and Pike, a small firm of five attorneys, three partners and two associates. The firm has a support staff of four, a receptionist, two secretaries and
one paralegal. In 1998, BW&P typically billed about $85,000 a month. The firm has ongoing monthly expenses of about $78,000.
On an accrual basis, the firm will show a net profit of nearly $7,000 per month, or about 8.2% of billings. Yet the three partners do not feel they are being fairly compensated, and,
indeed, they have a valid complaint. Look at their 1998 income statement (Table 1). The expense for Salaries is the amount paid to the two associates and support staff, plus a modest draw
for the partners (less than the associates' salaries); it does not include partners' compensation in the form of distributions. The partners each receive an equal share of the annual net
income, a paltry $89,971, or less than $30,000 per partner, assuming all of net income was distributed.
At the partners' meeting held in February, 1999, Bass, Walleye and Pike decided to make a concentrated effort to increase their profitability by the end of the current year. They believed
that by increasing advertising, aggressively seeking additional business, and maybe even adding staff they could drastically improve their bottom line. The results of their efforts are
shown in Table 1 under the column 1999. By December 31, 1999, billings had increased 55%, from $1,028,866 to $1,601,229. Net income had almost tripled, to $262,962. At the partners'
meeting in February, 2000, the three partners congratulated themselves on exceeding their goal. Six months later, in August, the firm was out of business and the partners were facing
bankruptcy.1 What happened?
Bigger is not Always Better
Perhaps you've heard it said that a business failed because "it grew too fast." What does that mean? Isn't growth good? After all, more
growth means more billings which means more revenue. Even though we've seen that accounting income doesn't always translate into cash in the bank when it's needed, wouldn't it be better
in the long run to have billings as high as possible? At some point that money will be collected and become cash. So what's the problem with growth?
The problem lies in another accounting concept called the balance sheet equation. Most people are familiar with this. The balance sheet equation simply says that assets must equal
liabilities plus equity (or net worth as it's sometimes called). The balance sheet equation cannot be violated; it has to hold. Thus, if assets increase, there must be a corresponding
increase in either liabilities or equity, or both. To see how this can cause problems when coupled with uncontrolled growth, consider the same firm's balance sheets at December 31, 1998
and 1999 (Table 2).
In this example, the balance sheet equation is satisfied. Total assets of $292,595 on December 31, 1998, were offset by total liabilities and equity of $292,595. Over the course of the
next year the firm increased its assets by $252,982. At the end of 1999, its accounts receivable increased 38% to $348,413. There was a modest increase of $49,347 in other assets as the
firm added equipment to handle the extra work. The increase in assets must be equaled by a similar increase in either liabilities or equity. Consider what this means to the firm. If
liabilities increase by $252,982, that means either the firm has borrowed another $252,982, increasing notes payable, or it has increased accounts payable, meaning it is stretching
creditors more and more, thereby increasing the likelihood of late payments and pressure from those creditors. On the other hand, the firm could increase its equity. There are only two
sources for equity: It can come from external sources (firm members) or equity can increase because of retained earnings (less distributions to firm members). Either way, the increase in
billings means less money at year end in the members' pockets. In our example, retained earnings increased, meaning the partners withdrew less money in 1999 than in the prior year and
liabilities increased as well. Thus, the firm, while becoming much more profitable actually returned less to its owners, the partners. Rather than solving the cash flow shortage,
increased billings ended up putting additional financial stress on the firm.
Does this mean that growth is bad? No, only that uncontrolled growth is bad. Properly managed growth is both desirable and ncessary for a firm's long term financial success. If a firm has
current financial statements (income statement and balance sheet) it can use a formula to calculate the sustainable growth rate (sgr), which is a number indicating at what rate a business
can grow without incurring financial stress. This formula is given as:
sgr =Profit margin x Retention ratio x Asset turnover x Asset/equity ratio
The profit margin is net profits/net sales or billings, and was $89,971/$1,028,866 for 1998, which equals .087.
The retention ratio is that portion of net income retained (not distributed to members) by the firm. Let us assume that the firm distributed 50% of its profits in 1998, thus retaining 50%.
As more profits are distributed to firm members, the retention ratio drops, as does the sustainable growth rate. This is logical, since more distributions to partners means less retained
earnings to support further growth.
Asset turnover is a measure of how efficiently assets are used. Capital intensive businesses, such as manufacturing firms, have low ratios. Service businesses, such as law firms,
accounting firms and the like, which have relatively little invested in fixed assets, have higher ratios. Asset turnover is the ratio of total sales to total assets, in this case
$1,028,866/$292,595, or 3.52, indicating the firm has relatively low investment in capital assets, as would be expected.
The asset to equity ratio is just that, the ratio of total assets to equity. Here it is $292,595/$102,488, or 2.85.
For this firm, the sustainable growth rate is .087 x .5 x 3.52 x 2.85 = .436, meaning the firm could grow at the rate of 43.6% per year without causing itself financial distress. Between
1998 and 1999, it actually grew at the rate of 55.6% based on 1999 billings vs. 1998 billings, or 12% over what it should have grown.2 No wonder the firm went out of business shortly
thereafter.
If your firm does not have current financial statements, don't feel bad. Only one in ten small businesses prepares financial statements regularly (this includes even a simple budget). Most
hurriedly throw one together only when they apply for a loan. If you don't have financial statements, get them. Trying to run a firm without current financial statements is a bit like
trying to cross examine a witness without a deposition. It can be done, but you're shooting in the dark.
Cash Flow Management
A closer look at the balance sheets for Bass, Walleye and Pike for December 31, 1998 and 1999, reveals an additional reason for its demise. Note how accounts
receivable increased. Clearly, this firm was not doing a good enough job of collecting its accounts. This is a common problem many small businesses face. The company is too busy
generating new business to worry about collecting from old customers. At the end of 1998, BW&P had $144,778 in accounts unpaid, or 14% of the year's billings. In 1999, it had 21% of
its billings uncollected at year end. Had it kept the ratio to 14%, it would have collected an additional $118,243 over the course of the year, or nearly $10,000 more per month.
Again, though, 1998 is not a good baseline because the firm was in distress even then. A more helpful measure for the firm would be its accounts receivable aging. This is a measure of what
portion of its accounts receivable are 30, 60 and 90+ days old. Ideally, all accounts should be collected within 90 days; accounts over 90 days old are generally considered to be
uncollectable. Perhaps BW&P could have better spent some of that increased salary expense on a credit manager.
Assume that the firm bills and collects a relatively equal amount in each of the twelve months of the year. Monthly billings for 1999 are, consequently, approximately $133,435. None of
December's work was billed as of December 31, 1999. Therefore, in order to end 1999 with $348,413 in accounts receivable, all of November's $133,435 billings were uncollected, all of
October's $133,435 billings were uncollected, and $81,543 of September's billings were uncollected. Since September's billings were based on work done in August and earlier, BW&P
ended 1999 without having collected for any work performed in the last third of the year!
Suppose that the firm had hired a credit manager, and this person had gotten clients to pay according to this schedule:
Within 30 days50%
Within 60 days40%
Within 90 days5%
Written off as bad debts 5%
Under this schedule, at December 31, the accounts receivable would consist of 50% of November's billing (because 50% was paid in December); 10% of October's billing (because 50% was paid
in November and another 40% was paid in December); and 5% of September's billing (because 50% was paid in October, 40% was paid in November and 5% was paid in December).
November billings outstanding (50%)$ 66,717
October billings outstanding (10%)$ 13,343
September billings outstanding (5%)$ 6,671
Total Accounts Receivable at year end$ 86,731
Additional cash to firm during 1999$261,682
It is easy to see that a credit manager would have been worth far more than the salary BW&P would have likely paid.
Watch Key Financial Indicators
We just saw how tracking aging of accounts receivable can be useful. There are many other financial indicators. You may want to consult with an
accountant or other financial professional to determine which are most useful for your particular situation. The point is, in order to become successful financially as an attorney, you
must have financial statements and know how to use them. Then, you must use them. Don't make the mistake of preparing financial statements annually and then not looking at them until the
next year. Review your statements at least monthly. Check on your receivables to see if clients are paying on time. Follow billings to make sure you are growing at the right pace. Look at
accounts payable. Late payments are usually indications of underlying problems. Compare the same month in different years. You may think that your firm receives its income fairly evenly
throughout the year, but you may be shocked to discover that is not the case at all.
Cull the Unprofitable Clients
Perhaps BW&P's accounts receivable were out of line because it picked deadbeat clients. The 80/20 rule applies to the practice of law just as
surely as it applies to other businesses. Simply put, the 80/20 rule says that 80% of a firm's revenue comes from 20% of its customers. Looked at conversely, 80% of your clients account
for only 20% of your income. Find those unprofitable clients and get rid of them! Obviously, ethical considerations may prevent you from simply sending them a letter telling them you will
no longer represent them, but as soon as the matter you've been retained to handle is completed, urge them to go elsewhere for their future needs.
Not all of the 80% will be deadbeats. One of the tricks you must master is how to determine which of those 80% can be moved into the 20% category (and, similarly, which of the 20% might
slip into the other group). Watch for signs of trouble, such as bills not being paid for longer periods of time. And, watch for signs of growth. Are they growing, stagnating or shrinking
their business? Get to know your clients' business. Not only will you be able to see potential trouble or potential opportunities in time to do something about them, you will also build a
relationship with your clients that can serve as the foundation for much more business in the future.
Conclusion
Cash flow management may be one of the most important things you can master to ensure your financial success. If you don't have the skill, time or inclination to do it
yourself, give serious consideration to employing an accountant or someone else who understands cash flow. As you can see from the example posed in this article, increasing billings is
not always the answer to cash shortages. Unless you are fond of daily conversations with creditors wanting money, neither is juggling accounts payable. And, unless you want to remain
perpetually in debt, bank loans aren't the answer either. The answer lies in cash flow management.
Footnotes
1 The figures in Tables 1 and 2 are from an actual business that filed bankruptcy in August, 2000. It was not a law firm; however, the numbers are real and unmodified.
2 The
rate of 43.6% is suspect to begin with because, as we noted, the firm was already experiencing financial distress which the partners thought could be remedied simply by increasing
billings.
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