The Vital Signs of Firm Profitability

The ultimate objective of law firm management is to create profit for owners. It is the role of a managing partner, management committee, and CFO to understand the elements that impact profitability, identify and improve weaknesses that soften profitability, and capitalize on opportunities to enhance profitability. As firms grow bigger and more complex, data become more valuable. But gathering data means nothing without useful reporting and disciplined review.

According to the 2011 Client Advisory from Hildebrandt Baker Robbins and Citi Private Bank [See Hildebrandt Baker Robbins, 2011 Client Advisory, January 2011], demand for legal services decreased during the past several years. Firms of all sizes saw an overall decline in demand in 2009 and flat performance at best in 2010. The largest firms took the biggest hit, but seem to be recovering slightly quicker. As one might imagine, bankruptcy and reorganization were the only practice areas seeing an uptick in business.

Well-managed firms can take this challenge as an opportunity to abandon laissez-faire management practices. With compensation flat or lower, improved business management and changes to firm culture may face less opposition.

The automatic reaction ' demand more billable hours from every professional ' won't always translate to profit. What if everyone in your Smithville office worked harder than ever, for example, but the additional hours related to fixed fee or contingent matters where the additional time could never be billed? What if one partner got busy on a complex litigation matter and delayed billing other clients until they no longer felt the true value of the work and (with their own revenue pressures) weren't willing to pay full rate? Rather than bemoan the decrease in billable hours and crack the whip, this is a good time to identify other key predictive indicators that impact profitability so that these indicators can be monitored and managed to improve profitability.

We propose a simple three-step process to improve your practice management.

1. Identify the vital signs or key performance indicators for your law firm.
2. Select or build the right reporting tools to make it easy to monitor those critical signs.
3. Establish a disciplined process to review those data, share them with partners as appropriate, and implement the changes they dictate. This, of course, is the most difficult step.

Key Performance Indicators

We define key performance indicators as metrics within any business that affect profitability. There are an infinite number of things you can measure, of course, but you can't look at everything. We recommend selecting a reasonable number of specific measures you might realistically expect to impact.

Of course you will track billable hours, billings, collections and certain cost and expense categories. You will look at WIP, accounts receivable, and write-offs. Collect and measure data at the lowest possible levels ' per lawyer, practice group level or office location ' so that you can compare with published benchmarks such as the annual Small Law Firm Economic Survey published each year by ALM Legal Intelligence (www.almlegalintelligence.com). Then aggregate the information into different views that make sense for your firm.

For example:

• If you generate revenue from more than one or two practice groups, you can review metrics at the practice group level.
• If you have more than one office, look at the performance of each one individually.
• If some of your work is done on contingency, monitor performance (hours, fees, collections, costs and expenses) and compare with non-contingency work.
• If your firm includes several merged entities, compare performance for each partner group.

Try to identify what you'll be able to learn from monitoring each indicator. Some variation in data may be due to economic conditions, which may lead you to increase business development activity for one area and decrease it for another. Some variation may be due to the culture of a partner group, or the management style of a practice leader. Other variations may be due to a significant client matter completed and not replaced. This may indicate a need to change staffing levels. With data in hand, you may have more influence.

Reporting

Keeping a watchful eye on the vital signs of your business and taking action when issues or opportunities arise can improve profits to partners or shareholders. But our decades of advising law firms have shown us, time and again, that it can be a challenge for management in many firms. Sometimes it's difficult to get the information. Sometimes there's so much information it's hard to focus on the right indicators. And sometimes it's easy to let other matters come first, so that it takes management too long to act. How you choose to gather and report information can make the process easier.

Let's consider several basic types of management information: financial statements, management reports, FLASH reports, real-time dashboards, exception reports, and e-mail alerts.

Financial Statements

Setting up your accounting systems properly can create a significant amount of useful reporting. Make sure your general ledger chart of accounts is elaborate enough to provide meaningful information, and provides the breakdowns you need. For example, set up different accounts for revenue and expenses by practice area or by location if these will be tracked separately. Make sure that you do not group too many uncommon items into one general ledger account. This makes the information you are looking at very difficult to interpret.

Customize regular monthly reports that provide a snapshot of firm activity during a specific time period, and allow comparison to the prior period, budgets and forecasts. If the accounting personnel aren't comfortable with the reporting options available in your accounting package (or if they tell you that what you want isn't available), ask your CPA firm for assistance. Beginning the year with the right data is critical.

Management Reports

Most management teams receive a regular package of printed monthly reports generated from your practice management system. Are you getting the right information and using it properly? Do the data allow you to see strengths and weaknesses across the firm? You may wish to see the data by originating attorney, responsible attorney, office location, practice area, client group, or client matter.

An important consideration here is the distribution list. If you want to foster a competitive spirit among professionals who work well together but have become complacent, then show them all how they're doing compared with each other. If you've recently completed a merger or acquisition, however, you may wish to restrict detailed data to the management team until the cultures become more aligned. This decision should be based on the culture and direction of the firm.

FLASH Reports

The FLASH report gives a frequent high-level picture of the firm's performance. Many businesses divide FLASH reports into liquidity, productivity and profitability indicators. The liquidity section reports on things like your cash position, WIP and A/R aging summaries, days in WIP and A/R, and line-of-credit balances. The productivity section shows the key performance metrics of the business. These may include measures of new clients and hours worked (compared with standards). The profitability section could include measures of billings, collections and write-downs. There may be other sections or indicators that are more important to your firm. The report should reflect current data in comparison with prior period data, so you can see trends. Make sure to keep the report to one page or two at the most.

Your accounting staff should set up an Excel template, and take no more than an hour or two to assemble data on a weekly, semi-monthly or monthly basis. Your CPA firm can be a valuable resource designing FLASH reports. We recommend reviewing these reports at every partner meeting. These reports should highlight trends and variances that all partners should understand.

Dashboards

Financial statements, monthly management reports, and even weekly FLASH reports may not provide all the tools needed for effective firm management. Real-time information through dashboards is an excellent tool to give management access to information about your clients and your people. We recommend you create dynamic dashboards based on the data in your database.

You might create a dashboard, for example, that allows you to look at hours, billings or collections for a time period you set, and sort or group data by originating attorney, responsible attorney, client group, practice group, or even industry. Or you could look at originations for a specific period by partner or by office if you track the commencement date for each new client matter. You could also check productivity stats by attorney, for other timekeepers, by practice area or by office. Whatever is in your database could be at your fingertips. You may need to consult the provider of your practice management system to create these dashboards, or to get your IT department trained to do so.

Exception Reports and e-Mail Alerts

If you establish guidelines or requirements for any part of your firm's operations (and we recommend that you do so), you must monitor compliance and hold people accountable. If you set a standard for monthly billing, which attorneys are not billing in a timely manner? If you require daily time sheets, who is not complying? Which A/R balances might be troubled based on delinquency that exceeds your standard number of days?

Consider the creation of exception reports that are provided to management to monitor the standards you set. e-Mail alerts to appropriate personnel can provide similar types of information on a more frequent basis. Like dashboards, these can be based on any information you enter into your system.

Key Performance Indicators to Consider for Your Law Firm

When we surveyed several of our law firm clients, including small, medium and large firms, these key performance indicators were considered among the most valuable to analyze financial results and to make managerial decisions:

Productivity Key Performance Indicators:

• Ratio of FTE associates to partners (split between equity and non-equity, if applicable) to measure the firm's leverage;
• Ratio of partners' hours (split between equity and non-equity, if applicable) to total billable hours by all timekeepers measures the firm's leverage;
• Ratio of billable hours to standard hours, for any or all of the following: attorney (associate, non-equity and equity), paralegal, practice area and office;
• Ratio of total billable hours for all professionals to number of legal assistants (by practice area or office, if applicable) to measure billable hours per legal assistant;
• Ratio of total number FTEs to the total number of FTE professionals to measure administrative staffing levels;
• Ratio of fees billed to fees incurred to measure the percent of attorney time that is actually billed;
• Ratio of fees collected to fees incurred to measure the percent of attorney time that is actually billed and collected;
• Total Billable Value divided by Working Days measures the average daily fees generated;
• Total Fees Billed divided by Working Days measures the average daily fees billed; and
• Total Fees Collected divided by Working Days measures the average daily fees collected.

Financial Key Performance Indicators:

• The following data should be accumulated on a monthly and year-over-year comparative basis in total and/or by practice area to observe trends and compute ratios: 1) Fees billed; 2) Fees collected; 3) Current AR/WIP; 4) A/R and WIP over 90 days (as $ and % of total); 5) Rate discounts in $; 6) Billed fee write-downs in $; 7) and A/R write-offs in $.
• Number of Calendar Days Unbilled WIP measures the length of time it takes to bill the work performed.
• Number of Calendar Days Outstanding A/R measures the length of time it takes to collect on invoices once they are rendered.
• Total number of Calendar Days Invested (Sum of days in WIP and A/R).
• Total $ WIP, A/R, plus hard and soft costs provides total exposure by client matter or group.
• Revenue per square foot by location.
• Ratio of net expenses (total expenses minus billings of all non-partner billers) to number of Partner FTEs (both equity and non-equity). This is the net cost each partner must cover before any profits are generated.
• Ratio of total amount of internal costs billed to clients divided by the total number of matters billed measures average cost recovery by matter.
• Overhead expenses expressed as percentages of revenues.
• Contingency WIP: Ratio of Contingent-Based WIP to total WIP.
• Top 50, 100 or all clients ranked by fees collected, fees billed, hours worked, and fees incurred compared with prior year.
• Ratio of employee overtime hours or $ (for employees subject to overtime pay) to total employee hours or $ (for employees subject to overtime pay) tracks trends in overtime payroll.

Client-Related Key Performance Indicators:

• Measuring the breadth of the client relationship: 1) Number of matters per client; 2) Number of practice areas that support each client; and 3)
  Number of professionals with time spent on matters connected to particular client.
• Ratio of the number of new clients (by practice area) to number of total active clients measures trends in the client growth rate;
• Ratio of total $ fees to total number of clients measures the average fee per client.
• Ratio of the total $ new client fees to total number of new clients measures the average fee per new client.
• Ratio of total marketing spend to total fees billed measures marketing efficiency.
• Ratio of business development spend to total fees billed measures the business spend efficiency. This may be more useful to benchmark by practice area, attorney or office.

Using the Data to Take Action

Data are worth nothing if you don't look at them. Data are worth almost nothing if you see trends or variances but take no action.

Be strategic about distribution of the meaningful data you collect. Create a disciplined process of action: management meetings, decision processes, and communication to the rest of the firm. Make sure everyone understands that this process is designed to improve firm profitability. And then hold people accountable for the behaviors you know will affect the key performance metrics that drive profitability.

Steven A. Davis, CPA, a member of this newsletter's Board of Editors, is an accounting service principal and is a member of the management committee for Kaufman, Rossin & Co. He and audit manager Marc Feigelson, CPA, provide a wide array of professional services for many law firm clients. They can be reached at [email protected] and [email protected].

The ultimate objective of law firm management is to create profit for owners. It is the role of a managing partner, management committee, and CFO to understand the elements that impact profitability, identify and improve weaknesses that soften profitability, and capitalize on opportunities to enhance profitability. As firms grow bigger and more complex, data become more valuable. But gathering data means nothing without useful reporting and disciplined review.

According to the 2011 Client Advisory from Hildebrandt Baker Robbins and Citi Private Bank [See Hildebrandt Baker Robbins, 2011 Client Advisory, January 2011], demand for legal services decreased during the past several years. Firms of all sizes saw an overall decline in demand in 2009 and flat performance at best in 2010. The largest firms took the biggest hit, but seem to be recovering slightly quicker. As one might imagine, bankruptcy and reorganization were the only practice areas seeing an uptick in business.

Well-managed firms can take this challenge as an opportunity to abandon laissez-faire management practices. With compensation flat or lower, improved business management and changes to firm culture may face less opposition.

The automatic reaction ' demand more billable hours from every professional ' won't always translate to profit. What if everyone in your Smithville office worked harder than ever, for example, but the additional hours related to fixed fee or contingent matters where the additional time could never be billed? What if one partner got busy on a complex litigation matter and delayed billing other clients until they no longer felt the true value of the work and (with their own revenue pressures) weren't willing to pay full rate? Rather than bemoan the decrease in billable hours and crack the whip, this is a good time to identify other key predictive indicators that impact profitability so that these indicators can be monitored and managed to improve profitability.

We propose a simple three-step process to improve your practice management.

1. Identify the vital signs or key performance indicators for your law firm.
2. Select or build the right reporting tools to make it easy to monitor those critical signs.
3. Establish a disciplined process to review those data, share them with partners as appropriate, and implement the changes they dictate. This, of course, is the most difficult step.

Key Performance Indicators

We define key performance indicators as metrics within any business that affect profitability. There are an infinite number of things you can measure, of course, but you can't look at everything. We recommend selecting a reasonable number of specific measures you might realistically expect to impact.

Of course you will track billable hours, billings, collections and certain cost and expense categories. You will look at WIP, accounts receivable, and write-offs. Collect and measure data at the lowest possible levels ' per lawyer, practice group level or office location ' so that you can compare with published benchmarks such as the annual Small Law Firm Economic Survey published each year by ALM Legal Intelligence (www.almlegalintelligence.com). Then aggregate the information into different views that make sense for your firm.

For example:

• If you generate revenue from more than one or two practice groups, you can review metrics at the practice group level.
• If you have more than one office, look at the performance of each one individually.
• If some of your work is done on contingency, monitor performance (hours, fees, collections, costs and expenses) and compare with non-contingency work.
• If your firm includes several merged entities, compare performance for each partner group.

Try to identify what you'll be able to learn from monitoring each indicator. Some variation in data may be due to economic conditions, which may lead you to increase business development activity for one area and decrease it for another. Some variation may be due to the culture of a partner group, or the management style of a practice leader. Other variations may be due to a significant client matter completed and not replaced. This may indicate a need to change staffing levels. With data in hand, you may have more influence.

Reporting

Keeping a watchful eye on the vital signs of your business and taking action when issues or opportunities arise can improve profits to partners or shareholders. But our decades of advising law firms have shown us, time and again, that it can be a challenge for management in many firms. Sometimes it's difficult to get the information. Sometimes there's so much information it's hard to focus on the right indicators. And sometimes it's easy to let other matters come first, so that it takes management too long to act. How you choose to gather and report information can make the process easier.

Let's consider several basic types of management information: financial statements, management reports, FLASH reports, real-time dashboards, exception reports, and e-mail alerts.

Financial Statements

Setting up your accounting systems properly can create a significant amount of useful reporting. Make sure your general ledger chart of accounts is elaborate enough to provide meaningful information, and provides the breakdowns you need. For example, set up different accounts for revenue and expenses by practice area or by location if these will be tracked separately. Make sure that you do not group too many uncommon items into one general ledger account. This makes the information you are looking at very difficult to interpret.

Customize regular monthly reports that provide a snapshot of firm activity during a specific time period, and allow comparison to the prior period, budgets and forecasts. If the accounting personnel aren't comfortable with the reporting options available in your accounting package (or if they tell you that what you want isn't available), ask your CPA firm for assistance. Beginning the year with the right data is critical.

Management Reports

Most management teams receive a regular package of printed monthly reports generated from your practice management system. Are you getting the right information and using it properly? Do the data allow you to see strengths and weaknesses across the firm? You may wish to see the data by originating attorney, responsible attorney, office location, practice area, client group, or client matter.

An important consideration here is the distribution list. If you want to foster a competitive spirit among professionals who work well together but have become complacent, then show them all how they're doing compared with each other. If you've recently completed a merger or acquisition, however, you may wish to restrict detailed data to the management team until the cultures become more aligned. This decision should be based on the culture and direction of the firm.

FLASH Reports

The FLASH report gives a frequent high-level picture of the firm's performance. Many businesses divide FLASH reports into liquidity, productivity and profitability indicators. The liquidity section reports on things like your cash position, WIP and A/R aging summaries, days in WIP and A/R, and line-of-credit balances. The productivity section shows the key performance metrics of the business. These may include measures of new clients and hours worked (compared with standards). The profitability section could include measures of billings, collections and write-downs. There may be other sections or indicators that are more important to your firm. The report should reflect current data in comparison with prior period data, so you can see trends. Make sure to keep the report to one page or two at the most.

Your accounting staff should set up an Excel template, and take no more than an hour or two to assemble data on a weekly, semi-monthly or monthly basis. Your CPA firm can be a valuable resource designing FLASH reports. We recommend reviewing these reports at every partner meeting. These reports should highlight trends and variances that all partners should understand.

Dashboards

Financial statements, monthly management reports, and even weekly FLASH reports may not provide all the tools needed for effective firm management. Real-time information through dashboards is an excellent tool to give management access to information about your clients and your people. We recommend you create dynamic dashboards based on the data in your database.

You might create a dashboard, for example, that allows you to look at hours, billings or collections for a time period you set, and sort or group data by originating attorney, responsible attorney, client group, practice group, or even industry. Or you could look at originations for a specific period by partner or by office if you track the commencement date for each new client matter. You could also check productivity stats by attorney, for other timekeepers, by practice area or by office. Whatever is in your database could be at your fingertips. You may need to consult the provider of your practice management system to create these dashboards, or to get your IT department trained to do so.

Exception Reports and e-Mail Alerts

If you establish guidelines or requirements for any part of your firm's operations (and we recommend that you do so), you must monitor compliance and hold people accountable. If you set a standard for monthly billing, which attorneys are not billing in a timely manner? If you require daily time sheets, who is not complying? Which A/R balances might be troubled based on delinquency that exceeds your standard number of days?

Consider the creation of exception reports that are provided to management to monitor the standards you set. e-Mail alerts to appropriate personnel can provide similar types of information on a more frequent basis. Like dashboards, these can be based on any information you enter into your system.

Key Performance Indicators to Consider for Your Law Firm

When we surveyed several of our law firm clients, including small, medium and large firms, these key performance indicators were considered among the most valuable to analyze financial results and to make managerial decisions:

Productivity Key Performance Indicators:

• Ratio of FTE associates to partners (split between equity and non-equity, if applicable) to measure the firm's leverage;
• Ratio of partners' hours (split between equity and non-equity, if applicable) to total billable hours by all timekeepers measures the firm's leverage;
• Ratio of billable hours to standard hours, for any or all of the following: attorney (associate, non-equity and equity), paralegal, practice area and office;
• Ratio of total billable hours for all professionals to number of legal assistants (by practice area or office, if applicable) to measure billable hours per legal assistant;
• Ratio of total number FTEs to the total number of FTE professionals to measure administrative staffing levels;
• Ratio of fees billed to fees incurred to measure the percent of attorney time that is actually billed;
• Ratio of fees collected to fees incurred to measure the percent of attorney time that is actually billed and collected;
• Total Billable Value divided by Working Days measures the average daily fees generated;
• Total Fees Billed divided by Working Days measures the average daily fees billed; and
• Total Fees Collected divided by Working Days measures the average daily fees collected.

Financial Key Performance Indicators:

• The following data should be accumulated on a monthly and year-over-year comparative basis in total and/or by practice area to observe trends and compute ratios: 1) Fees billed; 2) Fees collected; 3) Current AR/WIP; 4) A/R and WIP over 90 days (as $ and % of total); 5) Rate discounts in $; 6) Billed fee write-downs in $; 7) and A/R write-offs in $.
• Number of Calendar Days Unbilled WIP measures the length of time it takes to bill the work performed.
• Number of Calendar Days Outstanding A/R measures the length of time it takes to collect on invoices once they are rendered.
• Total number of Calendar Days Invested (Sum of days in WIP and A/R).
• Total $ WIP, A/R, plus hard and soft costs provides total exposure by client matter or group.
• Revenue per square foot by location.
• Ratio of net expenses (total expenses minus billings of all non-partner billers) to number of Partner FTEs (both equity and non-equity). This is the net cost each partner must cover before any profits are generated.
• Ratio of total amount of internal costs billed to clients divided by the total number of matters billed measures average cost recovery by matter.
• Overhead expenses expressed as percentages of revenues.
• Contingency WIP: Ratio of Contingent-Based WIP to total WIP.
• Top 50, 100 or all clients ranked by fees collected, fees billed, hours worked, and fees incurred compared with prior year.
• Ratio of employee overtime hours or $ (for employees subject to overtime pay) to total employee hours or $ (for employees subject to overtime pay) tracks trends in overtime payroll.

Client-Related Key Performance Indicators:

• Measuring the breadth of the client relationship: 1) Number of matters per client; 2) Number of practice areas that support each client; and 3)
  Number of professionals with time spent on matters connected to particular client.
• Ratio of the number of new clients (by practice area) to number of total active clients measures trends in the client growth rate;
• Ratio of total $ fees to total number of clients measures the average fee per client.
• Ratio of the total $ new client fees to total number of new clients measures the average fee per new client.
• Ratio of total marketing spend to total fees billed measures marketing efficiency.
• Ratio of business development spend to total fees billed measures the business spend efficiency. This may be more useful to benchmark by practice area, attorney or office.

Using the Data to Take Action

Data are worth nothing if you don't look at them. Data are worth almost nothing if you see trends or variances but take no action.

Be strategic about distribution of the meaningful data you collect. Create a disciplined process of action: management meetings, decision processes, and communication to the rest of the firm. Make sure everyone understands that this process is designed to improve firm profitability. And then hold people accountable for the behaviors you know will affect the key performance metrics that drive profitability.

Steven A. Davis, CPA, a member of this newsletter's Board of Editors, is an accounting service principal and is a member of the management committee for Kaufman, Rossin & Co. He and audit manager Marc Feigelson, CPA, provide a wide array of professional services for many law firm clients. They can be reached at [email protected] and [email protected].