Managing Fiscal Fundamentals

Cash flow is not the same thing as income. Even for law firms who measure their economic performance on the cash basis, there are borrowings, loan payments, fixed asset purchases and depreciation that affect income and cash flow differently. Obviously these financing and investment activities are important, but they are not where law firms get into trouble (unless they have financed operations instead of investments). Generally, trouble occurs if there is insufficient focus on the cash receipts generated from accounts receivable and the cash payments generated by payroll and accounts payable.

The difference (cash gap) between these two cash streams is extremely important. The cash gap in a law firm is defined as the difference between when you pay your expenses and when clients pay you. For law firms, this number has historically been about 105 days. Unbilled time (ie, time not yet billed) turns over in 60-70 days, and accounts receivable turnover is 60-80 days. By contrast, accounts payable are generally only around 30 days. But the great challenge is that labor's cash gap is closer to 120 days. This is critical because labor costs are the single largest overhead item, and salaries typically must be paid biweekly or semi-monthly. (Rampant increases of associate wages in recent years compounded this difficulty.) See Cash Gap diagram on page 6.

What this means is that as you operate your business, you are likely to have paid the costs to render services before you have even invoiced the client. If your time recording, billing and collection processes are inefficient or ineffective, your ability to promptly generate timely fee collections is severely strained. To quote an executive director, 'If we do not have time in the system, we cannot bill our clients. If we cannot bill for services, money does not come in the door. If we have no money, we cannot pay bills '.' So simple, yet successfully managing this basic function remains a problem in many law firms.

Surprisingly, if you are growing your business, the cash gap is even more critical. It is possible to grow a business so rapidly that you literally grow it into bankruptcy. Even a profitable business can falter, because growth requires ever-increasing outlays of cash ' while the growth in cash receipts lags. If your capital is inadequate, you consume all of your cash and then you are in trouble.

Think about what happens when you add an associate. Day one the associate begins work. Yours is an efficient law firm, so the associate is put on billable matters fairly quickly. By the end of the second week, when the individual receives the first paycheck, he or she is busy on client work. At the end of the month, the second paycheck comes; the associate is still busy. First of second month, benefits begin. Middle of second month, the partner returns the pre-bills back to accounting and the third paycheck is issued to the new associate. End of second month, the bill is mailed to the client and the fourth paycheck is issued. By now you can see where this is heading. We are up to four paychecks by the time a bill has gone out (if you are lucky). And we have not mentioned paying for the laptop computer or other direct marginal costs of the individual, let alone any incremental general overhead. Did we mention the 60 days or more until the client pays? Multiply that cost by inefficiencies along the way and then again by the number of associates you hire each year.

Revenues or Collected Fee Receipts: In addition to minding the cash gap, law firms also must focus on sustainable profits. Banks do not want to lend money to sustain partner incomes, so the success of the enterprise requires real economic profit. In law firms, the level of profits is dependent on the level of collected fee receipts (revenues) more than any other factor. This metric is so important for measuring productivity, and hence profitability, that it should be your primary focus of attention as a fiscal manager. View collected fee receipts in many ways: trends by year, current month versus same month prior year, actual versus plan, and actual versus relevant industry benchmarks.

When examined in the aggregate, your firm's revenues measured as a percentage of some other industry aggregate (city, state, region, etc.) can tell you what market share you are getting. If your market share is increasing (ie, your revenues are growing faster than the market segment you are measuring against), this suggests how effectively you are penetrating the market. But do not be fooled by the heady illusion of success just because revenue or even your market share is growing. If the new revenues are from clients that are not consistent with your strategy, or are not profitable, or are not sustainable, then you may have a fiscal problem that is also growing.

This article will conclude next month, with Part Two: Productivity, Pricing and Profit.

James D. Cotterman is a principal with management consultants Altman Weil, Inc. in Newtown Square, PA. He advises clients on economic issues, mergers and acquisitions, compensation systems, governance and management. Having served for two editions as lead author and editor of the ABA-published book Compensation Plans for Law Firms, Jim is currently preparing the 4th edition. A licensed CPA and member of AICPA, Mr. Cotterman also holds Operations Management and MBA degrees from Syracuse University.

Understanding a law firm's fiscal affairs is not that difficult. One need only understand a few basic concepts ' concepts that are no different for the law firm or the law firm's clients. The trick is not in understanding the numbers but in managing for results. For a law firm, this is an even greater challenge. Its owners are well educated, strong willed, success driven, practice focused, independent minded and, at least for trial lawyers, somewhat more argumentative than the general population. The owners are also large in number relative to the total number of employees and are active in the day-to-day operations of the firm.

Key Fiscal Performance Measures

Cash Flow and Cash Gap ' The lifeblood of any business is its ability to generate positive cash flow. It does not matter if you are Exxon or the neighborhood pizza shop. Positive cash flow is a requirement. That basic concept was temporarily forgotten with the dot-com companies in the latter half of the 1990s. The sudden and severe loss of market value in those companies during 2000 was primarily due to the re-emergence of this business fundamental.

Cash flow is not the same thing as income. Even for law firms who measure their economic performance on the cash basis, there are borrowings, loan payments, fixed asset purchases and depreciation that affect income and cash flow differently. Obviously these financing and investment activities are important, but they are not where law firms get into trouble (unless they have financed operations instead of investments). Generally, trouble occurs if there is insufficient focus on the cash receipts generated from accounts receivable and the cash payments generated by payroll and accounts payable.

The difference (cash gap) between these two cash streams is extremely important. The cash gap in a law firm is defined as the difference between when you pay your expenses and when clients pay you. For law firms, this number has historically been about 105 days. Unbilled time (ie, time not yet billed) turns over in 60-70 days, and accounts receivable turnover is 60-80 days. By contrast, accounts payable are generally only around 30 days. But the great challenge is that labor's cash gap is closer to 120 days. This is critical because labor costs are the single largest overhead item, and salaries typically must be paid biweekly or semi-monthly. (Rampant increases of associate wages in recent years compounded this difficulty.) See Cash Gap diagram on page 6.

What this means is that as you operate your business, you are likely to have paid the costs to render services before you have even invoiced the client. If your time recording, billing and collection processes are inefficient or ineffective, your ability to promptly generate timely fee collections is severely strained. To quote an executive director, 'If we do not have time in the system, we cannot bill our clients. If we cannot bill for services, money does not come in the door. If we have no money, we cannot pay bills '.' So simple, yet successfully managing this basic function remains a problem in many law firms.

Surprisingly, if you are growing your business, the cash gap is even more critical. It is possible to grow a business so rapidly that you literally grow it into bankruptcy. Even a profitable business can falter, because growth requires ever-increasing outlays of cash ' while the growth in cash receipts lags. If your capital is inadequate, you consume all of your cash and then you are in trouble.

Think about what happens when you add an associate. Day one the associate begins work. Yours is an efficient law firm, so the associate is put on billable matters fairly quickly. By the end of the second week, when the individual receives the first paycheck, he or she is busy on client work. At the end of the month, the second paycheck comes; the associate is still busy. First of second month, benefits begin. Middle of second month, the partner returns the pre-bills back to accounting and the third paycheck is issued to the new associate. End of second month, the bill is mailed to the client and the fourth paycheck is issued. By now you can see where this is heading. We are up to four paychecks by the time a bill has gone out (if you are lucky). And we have not mentioned paying for the laptop computer or other direct marginal costs of the individual, let alone any incremental general overhead. Did we mention the 60 days or more until the client pays? Multiply that cost by inefficiencies along the way and then again by the number of associates you hire each year.

Revenues or Collected Fee Receipts: In addition to minding the cash gap, law firms also must focus on sustainable profits. Banks do not want to lend money to sustain partner incomes, so the success of the enterprise requires real economic profit. In law firms, the level of profits is dependent on the level of collected fee receipts (revenues) more than any other factor. This metric is so important for measuring productivity, and hence profitability, that it should be your primary focus of attention as a fiscal manager. View collected fee receipts in many ways: trends by year, current month versus same month prior year, actual versus plan, and actual versus relevant industry benchmarks.

When examined in the aggregate, your firm's revenues measured as a percentage of some other industry aggregate (city, state, region, etc.) can tell you what market share you are getting. If your market share is increasing (ie, your revenues are growing faster than the market segment you are measuring against), this suggests how effectively you are penetrating the market. But do not be fooled by the heady illusion of success just because revenue or even your market share is growing. If the new revenues are from clients that are not consistent with your strategy, or are not profitable, or are not sustainable, then you may have a fiscal problem that is also growing.

This article will conclude next month, with Part Two: Productivity, Pricing and Profit.

James D. Cotterman is a principal with management consultants Altman Weil, Inc. in Newtown Square, PA. He advises clients on economic issues, mergers and acquisitions, compensation systems, governance and management. Having served for two editions as lead author and editor of the ABA-published book Compensation Plans for Law Firms, Jim is currently preparing the 4th edition. A licensed CPA and member of AICPA, Mr. Cotterman also holds Operations Management and MBA degrees from Syracuse University.