Financial Analysis: Critical to Sound Strategy

With the legal landscape in constant flux ' including numerous high- and low- profile mergers, dissolutions and consolidations ' leaders of most law firms have been forced, willingly or no, to engage in some serious strategic thinking about their firm's future. For many firms, however, “thinking strategically” has failed to produce quality strategy.

Among many reasons for this failure is a common error: not basing strategy on a hard-headed assessment of the firm's current position. Such an assessment requires a thorough analysis not only of the firm's external environment but also of its internal condition and capabilities.

As an important component of this analysis, the firm should conduct a rigorous analysis of the financial and client information available from its own accounting system ' an often overlooked gold mine of information about the firm and its practices.

Strategic Questions

What types of strategic questions can be answered, at least in part, from the firm's own financial data? Some of the more important ones include:

How is the firm doing, overall?

• What are its profits per partner? (With some external knowledge, you can answer the question of how well it's doing relative to key competitors.)

[Editor's Note: See our May and June issues for insights on law firm performance comparisons.]

• How is the firm performing relative to its potential? That is, how much better could the firm be doing if it were operating at full capacity, with leverage where it should be given its practices, and with billing and collecting at reasonable levels?
• Does the firm have a sound financial structure and capital base, given its goals and objectives?

How does the firm make money?

• Is the firm properly leveraged?
• Is there an appropriate balance between the firm's rate structure and its cost structure?
• What practices/offices are profitable, and why?
• What practices/offices are unprofitable, and why?
• How can profitability be improved?

Which practices are investments, and which are generating funds to invest in new areas?

• What is the firm's overall capacity for investment? (This question requires both some financial data and some judgment about the current culture and condition of the firm.)

How does work flow around the firm?

• Does the firm do a good job “cross-selling” its practices?
• What is the economic relationship among the practices? Among the offices?
• Do practices work together, or is work hoarded in certain areas of the firm?

What are the trends associated with the firm's key/core clients?

• Is work from core clients declining?
• Is the rate structure eroding?
• Are the firm's core clients profitable? How can they be made more profitable?

Understanding the firm's economic performance and capabilities will enable the leaders to make better strategic decisions, increasing the probability of success and improving profitability. Operational and administrative decisions that are essential to supporting the firm's strategic growth – such as decisions about leverage and necessary investments in resources like technology or research tools ' can be supported through solid financial analysis.

Good decisions on strategic issues regarding which services to offer, core client base to target, and optimal geographic expansion or consolidation can also be better made with a solid understanding of the financial implications of those decisions.

Given a veritable sea of available accounting and financial data, however, where should a firm's leaders focus their attention? At least three categories of information should be taken into consideration:

• Overall financial posture;
• Client economic data; and
• Performance data for each office (where relevant) and practice group.

Overall Financial Position

Most law firm leaders have at least a general understanding of the overall financial performance of their firm, and some have a very strong understanding. Many now realize that the old simplistic approach ' “Bill more hours and get the rates up” – masked a great deal of texture in the firm's financial performance. Beyond the leadership group, however, it is also important that other partners have a good understanding of the firm's economic performance.

After all, it's the partners at large who must buy into the firm's strategy. Partners must therefore clearly understand the levers that both contribute and take away from their firm's profitability. And they must know the level of impact of each.

The five key levers of profitability are price (rates), capacity utilization (average hours), realization, leverage and cost structure. All of these should be reviewed, along with higher-level indicators such as profit per partner, revenue per lawyer and the like. For most purposes, converting the analysis to a “per lawyer” or a “per partner” approach provides the clearest picture of where the firm actually is, and allows comparisons with other firms ' to the extent that truly comparable information is available.

To determine the firm's strategic starting point, the firm's leadership will also want to assess other key variables in the firm's overall financial position. These include:

• Balance sheet factors, such as capital and debt, and “off-balance sheet” liabilities such as lease commitments and retirement plans.
• Billing and collection performance statistics, such as inventory aging and turnover, write-offs and the like.
• Hours distribution, in addition to averages.
• Compensation distribution.
• Overhead and cost analyses.

Client Data

A clear understanding of the firm's client base is critical to strategy development; and a lot can be learned about the client base from the firm's financial records. It is particularly essential to understand the firm's existing core clients and how they contribute to the firm's current profitability. Have they imposed restrictions on pricing that result in weak profitability? Are they so concentrated by industry as to place the firm at risk from shifts in those industries? Are they so slow to pay invoices that they create cash flow problems?

Understanding the following information will help answer these questions and also help identify candidates for targeting as future core clients:

• Fees for the firm's top clients (by client industry and individually).
• Profitability analysis for the firm's top clients.
• Realization rate for each of the firm's top clients.
• Cross-selling data for the firm's top clients, including scope of services utilized, range of lawyers providing services, and the like.
• Growth analysis for the top clients, including both revenue and hours committed.

To put this analysis of core clients in context, it's helpful to also examine the firm's other clients. What, for example, are the average fees for the bottom 10% of clients?

Client data, when used correctly, helps the partners better understand the kinds of clients the firm represents. It also helps them understand whether the firm's largest clients are truly profitable for the firm; in a surprising number of cases, they turn out to be unprofitable! Such analysis will therefore be critical in focusing the firm on its desired core-client base, and hence its strategic positioning.

Office and Practice Group Data

Strategic thinking is often driven by a desire to diversify or consolidate practice areas or geography. In considering what core services a firm should offer and where it should offer those services, various financial analyses will be helpful. These include:

• Cross-selling reports, or “import-export schedules,” by both practice and by office. The example below shows that a partner in Practice Group B cross-sold work resulting in $25,000 for Practice Group A and $10,000 for Practice Group C, while generating $500,000 for its own lawyers.
• Analysis of practice profitability.

Note: There are a number of ways to analyze profitability, and none of them is perfect. Not surprisingly, profitability data tends to be extremely sensitive and should be used with significant discretion.

• For each practice area and office:
  • Average standard rate by level of timekeeper
  • Average billed rate by level of timekeeper
  • Average billable hours by level of timekeeper
  • Leverage rates
  • Realization rate for work done

As with core-client data, practice- or office-level financials are of limited value if viewed in a vacuum. Such data needs to be viewed comparatively and with a view toward understanding the profitability drivers for each office or practice group.

[IMGCAP(1)]

The goal is to assess where the opportunities are for both improvement of performance and for overall advancement of the firm's position. What elements, if changed, could enhance or damage the firm's success? Where should the firm invest? What trends in a practice or geographical area pose opportunities or threats to the firm's future? How do the firm's services complement one another? For these and similar strategic questions, analyzing the financial performance of offices and practice groups can help provide answers.

Conclusion

To make sound strategic decisions, partners must understand the firm's economic position and the tools with which they can improve that position. Looking in the financial mirror and understanding the data are critical first steps in charting a successful strategy.

With the legal landscape in constant flux ' including numerous high- and low- profile mergers, dissolutions and consolidations ' leaders of most law firms have been forced, willingly or no, to engage in some serious strategic thinking about their firm's future. For many firms, however, “thinking strategically” has failed to produce quality strategy.

Among many reasons for this failure is a common error: not basing strategy on a hard-headed assessment of the firm's current position. Such an assessment requires a thorough analysis not only of the firm's external environment but also of its internal condition and capabilities.

As an important component of this analysis, the firm should conduct a rigorous analysis of the financial and client information available from its own accounting system ' an often overlooked gold mine of information about the firm and its practices.

Strategic Questions

What types of strategic questions can be answered, at least in part, from the firm's own financial data? Some of the more important ones include:

How is the firm doing, overall?

• What are its profits per partner? (With some external knowledge, you can answer the question of how well it's doing relative to key competitors.)

[Editor's Note: See our May and June issues for insights on law firm performance comparisons.]

• How is the firm performing relative to its potential? That is, how much better could the firm be doing if it were operating at full capacity, with leverage where it should be given its practices, and with billing and collecting at reasonable levels?
• Does the firm have a sound financial structure and capital base, given its goals and objectives?

How does the firm make money?

• Is the firm properly leveraged?
• Is there an appropriate balance between the firm's rate structure and its cost structure?
• What practices/offices are profitable, and why?
• What practices/offices are unprofitable, and why?
• How can profitability be improved?

Which practices are investments, and which are generating funds to invest in new areas?

• What is the firm's overall capacity for investment? (This question requires both some financial data and some judgment about the current culture and condition of the firm.)

How does work flow around the firm?

• Does the firm do a good job “cross-selling” its practices?
• What is the economic relationship among the practices? Among the offices?
• Do practices work together, or is work hoarded in certain areas of the firm?

What are the trends associated with the firm's key/core clients?

• Is work from core clients declining?
• Is the rate structure eroding?
• Are the firm's core clients profitable? How can they be made more profitable?

Understanding the firm's economic performance and capabilities will enable the leaders to make better strategic decisions, increasing the probability of success and improving profitability. Operational and administrative decisions that are essential to supporting the firm's strategic growth – such as decisions about leverage and necessary investments in resources like technology or research tools ' can be supported through solid financial analysis.

Good decisions on strategic issues regarding which services to offer, core client base to target, and optimal geographic expansion or consolidation can also be better made with a solid understanding of the financial implications of those decisions.

Given a veritable sea of available accounting and financial data, however, where should a firm's leaders focus their attention? At least three categories of information should be taken into consideration:

• Overall financial posture;
• Client economic data; and
• Performance data for each office (where relevant) and practice group.

Overall Financial Position

Most law firm leaders have at least a general understanding of the overall financial performance of their firm, and some have a very strong understanding. Many now realize that the old simplistic approach ' “Bill more hours and get the rates up” – masked a great deal of texture in the firm's financial performance. Beyond the leadership group, however, it is also important that other partners have a good understanding of the firm's economic performance.

After all, it's the partners at large who must buy into the firm's strategy. Partners must therefore clearly understand the levers that both contribute and take away from their firm's profitability. And they must know the level of impact of each.

The five key levers of profitability are price (rates), capacity utilization (average hours), realization, leverage and cost structure. All of these should be reviewed, along with higher-level indicators such as profit per partner, revenue per lawyer and the like. For most purposes, converting the analysis to a “per lawyer” or a “per partner” approach provides the clearest picture of where the firm actually is, and allows comparisons with other firms ' to the extent that truly comparable information is available.

To determine the firm's strategic starting point, the firm's leadership will also want to assess other key variables in the firm's overall financial position. These include:

• Balance sheet factors, such as capital and debt, and “off-balance sheet” liabilities such as lease commitments and retirement plans.
• Billing and collection performance statistics, such as inventory aging and turnover, write-offs and the like.
• Hours distribution, in addition to averages.
• Compensation distribution.
• Overhead and cost analyses.

Client Data

A clear understanding of the firm's client base is critical to strategy development; and a lot can be learned about the client base from the firm's financial records. It is particularly essential to understand the firm's existing core clients and how they contribute to the firm's current profitability. Have they imposed restrictions on pricing that result in weak profitability? Are they so concentrated by industry as to place the firm at risk from shifts in those industries? Are they so slow to pay invoices that they create cash flow problems?

Understanding the following information will help answer these questions and also help identify candidates for targeting as future core clients:

• Fees for the firm's top clients (by client industry and individually).
• Profitability analysis for the firm's top clients.
• Realization rate for each of the firm's top clients.
• Cross-selling data for the firm's top clients, including scope of services utilized, range of lawyers providing services, and the like.
• Growth analysis for the top clients, including both revenue and hours committed.

To put this analysis of core clients in context, it's helpful to also examine the firm's other clients. What, for example, are the average fees for the bottom 10% of clients?

Client data, when used correctly, helps the partners better understand the kinds of clients the firm represents. It also helps them understand whether the firm's largest clients are truly profitable for the firm; in a surprising number of cases, they turn out to be unprofitable! Such analysis will therefore be critical in focusing the firm on its desired core-client base, and hence its strategic positioning.

Office and Practice Group Data

Strategic thinking is often driven by a desire to diversify or consolidate practice areas or geography. In considering what core services a firm should offer and where it should offer those services, various financial analyses will be helpful. These include:

• Cross-selling reports, or “import-export schedules,” by both practice and by office. The example below shows that a partner in Practice Group B cross-sold work resulting in $25,000 for Practice Group A and $10,000 for Practice Group C, while generating $500,000 for its own lawyers.
• Analysis of practice profitability.

Note: There are a number of ways to analyze profitability, and none of them is perfect. Not surprisingly, profitability data tends to be extremely sensitive and should be used with significant discretion.

• For each practice area and office:
  • Average standard rate by level of timekeeper
  • Average billed rate by level of timekeeper
  • Average billable hours by level of timekeeper
  • Leverage rates
  • Realization rate for work done

As with core-client data, practice- or office-level financials are of limited value if viewed in a vacuum. Such data needs to be viewed comparatively and with a view toward understanding the profitability drivers for each office or practice group.

[IMGCAP(1)]

The goal is to assess where the opportunities are for both improvement of performance and for overall advancement of the firm's position. What elements, if changed, could enhance or damage the firm's success? Where should the firm invest? What trends in a practice or geographical area pose opportunities or threats to the firm's future? How do the firm's services complement one another? For these and similar strategic questions, analyzing the financial performance of offices and practice groups can help provide answers.

Conclusion

To make sound strategic decisions, partners must understand the firm's economic position and the tools with which they can improve that position. Looking in the financial mirror and understanding the data are critical first steps in charting a successful strategy.