Law by the Numbers

Statistical analysis can be a practical tool to help any lawyer measure personal and firm performance against objective standards. This makes “The Business of Law'” understandable ' and makes the firm stronger as a result. Every law firm is a business and every business should know where it's going. Lawyers who understand statistical analysis of their firm's operation can explore operating efficiencies, gauge the firm's performance relative to its financial goals, and better assess and reflect value to clients in their bills.

This can be a challenge because too often the firm's owners lack basic business knowledge. Even partners may not possess the business competency to calculate, or even understand, the traditional key measures of law firm performance: realization, utilization, leverage and expenses. Many don't know, or understand, the firm's collection rate ' or even their own personal one. This is not to say that lawyers are oblivious to all financial numbers. The trend of national legal magazines publicly reporting annual financial information for the biggest law firms has transformed the profession's outlook. For the first time there was comparative data on revenue per partner, earnings per partner, and similar measures. Unfortunately, just like companies trying to impress investors and competitors, law firms began to make decisions based on maximizing revenue and profits per partner ' and neglecting financial basics.

Declining Fundamentals

A recent comprehensive statistical analysis by Georgetown Law School's Center for the Study of the Legal Profession, titled 2013 Report on the State of the Legal Market , illustrates how the financial fundamentals of major law firms are declining even as those firms focus on maximizing compensation metrics. (The report is available at http://bit.ly/191cxcT.) The study analyzed a detailed database of law firm performance statistics to show these disturbing trends:

• During 2012, the number of lawyers in U.S. firms grew by 2%, at the same time the demand for legal services grew by only 0.5%. As a result, productivity ' defined as the total number of billable hours recorded by a firm divided by the total number of lawyers in the firm ' declined by 1.5%. When measured in terms of billable hours per month per lawyer, productivity has been essentially flat for the past three years at '130.
• Realization rates (amount of money billed that is collected) averaged 83.6% for all law firms studied, a figure that is an historic low and some 8% lower than the 92% level at the end of 2007. For the 100 largest firms, the realization rate is even lower, at 82.8%.
• The firms covered in the analysis raised their rates on average 3.4% during 2012. While this increase was well below the 6% to 8% range seen annually during the pre-recession period, it was consistent with rate trends over the past three or four years, and well above the growth in both demand and expenses.
• Firms cut expenses dramatically from mid-2008 to mid-2010, when expenses began increasing again. This renewed growth, at a rate of about 5% annually, was perhaps not surprising since many of the expense “cuts” were really only deferrals of expenditures that had to be made sooner or later rather than eliminations of specific cost items.

These numbers do not create a picture of good financial health. But they do illustrate how the concept of benchmarking ' setting up statistical guidelines to identify best management practices ' can be a tremendous benefit to law firms. The appropriate statistical benchmarks can identify operating deficiencies in the firm, illustrate where the firm is currently relative to its goals, and provide fact-based information to gain consensus among partners. Financial benchmarking helps law firms measure their business effectiveness by analyzing profitability, cash flow and collections to better assess the value provided to clients and better reflect it in their bills.

Benchmarking Fundamentals

Benchmarking focuses on profitability, reflecting the value creation dynamic of any business enterprise: Profits equal Revenues minus Expenses; in other words, P = R – E. Although this is a simple equation, there are a number of performance factors that underlie it to determine a firm's profitability, including:

• Billing rates, whether hourly, blended (an average), fixed fee or other measure;
• Utilization, the percentage of a workweek (usually expressed as an annual average) that a lawyer actually bills;
• Realization, the amount of time actually billed and collected;
• Leverage, defined as the ratio of non-partners (associates, paralegals, staff) to partners; and
• Expenses, related to both operations and compensation, as a percent of revenues.

Billing rates are important, but should not be over-emphasized. The key to any law firm's performance is realizing the money collected from hours billed. This realization is sometimes discussed in two levels: Billed to billable ratio (the percent of billable or booked hours billed), and collected to billed ration (percent of billed work collected). The goal is to have a high collected-to-billable ratio. An overall realization of less than 85% is a recipe for trouble, because it means the firm has to treat 85% of its billings as 100% of its revenue.

Cash flow is the benchmark that ties these elements together. All organizations, large and small, law firms and non-law firms, have a second thing in common beyond cash flow: the three categories of expenditures for which cash flow is used.

1. Non-discretionary (mandatory) spending that is required by current obligations and by law: debt repayment, insurance, Social Security and federal income tax payments.
2. Adjustable spending that is important but can be modified (such as lease terms and staffing).
3. Discretionary spending that could be eliminated if necessary.

What is unique to law firms is the impact so many individuals have directly on discretionary spending, and thus on cash flow. In many law firms, individual partners can direct discretionary resource consumption. This may involve anything from purchasing new office furniture to charging the firm with personal meals and travel to making a commitment for a firm-sponsored table at a charity dinner. Adjusting the lawyers' compensation to financially appropriate levels, controlling or eliminating individually directed discretionary spending, in accordance with the revenue and expenses of the firm, and keeping debt only for long-term purchases (not for lawyers' draws or pet projects) is the only way to protect cash flow and keep a law firm vibrant and afloat.

Analytical Fundamentals

That brings us back to our original premise: too few lawyers understand these financial dynamics. Admittedly, today's financial information systems and software can ' and do ' produce extremely detailed assessments of financial performance to benchmarks, including the vital tracking of cash flow performance. However, many of these programs tend to provide far more data than can be assimilated intelligently. Some of these tools make the assessment process virtually automatic, and point out major variances for attention. These products can take the raw accounting information from individual firms and compile them with similar accounting information from other law firms. Then, the information can be filtered into quartiles such that all law firms that participate can assess where they are relative to other firms.

But such complexity of data raises the concern of conveying the information so that it is usable. A good analytical analogy can be made to driving a car. All the driver behind the wheel wants to do is glance at the dashboard and see the speed, the efficiency of how the engine is running, and how much fuel is left. This “dashboard” concept can be applied to the benchmarked financial information compiled by software programs, with important financial metrics displayed in an easy to understand visual format for presentation to law firm management. Information on the digital dashboard should be visually appealing, presented either as bar graphs or line charts. It should not try to display too much information on one visual ' no more than the current 12-month trend plus the same month of the prior year is a good reference point. Use longer timeframes where appropriate. A graph of profits per partner, for example, might show five years of results.

The most important goal of creating and evaluating a financial dashboard is to spot problems quickly and adjust the firm's activities so that financials remain positive. The dashboard concept shows that financial benchmarking and analysis needn't involve mastering management jargon or looking at things through the eyes of an MBA. Many lawyers, whose undergraduate and law school training had little practical business focus, think either they can't or shouldn't be business-minded. That is why analysis alone is not enough. Lawyers still must possess the desire and make the fundamental effort to understand what financial benchmarks mean and why they are important. This is nothing less than their moral obligation as owners of the firm. It takes commitment to such an obligation for benchmarking to be effective, no matter how sophisticated or understandable the analytical tools are that the firm uses.

Ed Poll, J.D., M.B.A., CMC, Principal, LawBiz Management, helps law firms increase profitability, coaching them on issues of internal operations, practice development and financial matters. A member of this newsletter's Board of Editors, he can be reached at 800-837-5880, www.lawbiz.com, www.lawbizblog.com and www.lawbizforum.com. Edward Poll ' All rights reserved ' 2013.

Statistical analysis can be a practical tool to help any lawyer measure personal and firm performance against objective standards. This makes “The Business of Law'” understandable ' and makes the firm stronger as a result. Every law firm is a business and every business should know where it's going. Lawyers who understand statistical analysis of their firm's operation can explore operating efficiencies, gauge the firm's performance relative to its financial goals, and better assess and reflect value to clients in their bills.

This can be a challenge because too often the firm's owners lack basic business knowledge. Even partners may not possess the business competency to calculate, or even understand, the traditional key measures of law firm performance: realization, utilization, leverage and expenses. Many don't know, or understand, the firm's collection rate ' or even their own personal one. This is not to say that lawyers are oblivious to all financial numbers. The trend of national legal magazines publicly reporting annual financial information for the biggest law firms has transformed the profession's outlook. For the first time there was comparative data on revenue per partner, earnings per partner, and similar measures. Unfortunately, just like companies trying to impress investors and competitors, law firms began to make decisions based on maximizing revenue and profits per partner ' and neglecting financial basics.

Declining Fundamentals

A recent comprehensive statistical analysis by Georgetown Law School's Center for the Study of the Legal Profession, titled 2013 Report on the State of the Legal Market , illustrates how the financial fundamentals of major law firms are declining even as those firms focus on maximizing compensation metrics. (The report is available at http://bit.ly/191cxcT.) The study analyzed a detailed database of law firm performance statistics to show these disturbing trends:

• During 2012, the number of lawyers in U.S. firms grew by 2%, at the same time the demand for legal services grew by only 0.5%. As a result, productivity ' defined as the total number of billable hours recorded by a firm divided by the total number of lawyers in the firm ' declined by 1.5%. When measured in terms of billable hours per month per lawyer, productivity has been essentially flat for the past three years at '130.
• Realization rates (amount of money billed that is collected) averaged 83.6% for all law firms studied, a figure that is an historic low and some 8% lower than the 92% level at the end of 2007. For the 100 largest firms, the realization rate is even lower, at 82.8%.
• The firms covered in the analysis raised their rates on average 3.4% during 2012. While this increase was well below the 6% to 8% range seen annually during the pre-recession period, it was consistent with rate trends over the past three or four years, and well above the growth in both demand and expenses.
• Firms cut expenses dramatically from mid-2008 to mid-2010, when expenses began increasing again. This renewed growth, at a rate of about 5% annually, was perhaps not surprising since many of the expense “cuts” were really only deferrals of expenditures that had to be made sooner or later rather than eliminations of specific cost items.

These numbers do not create a picture of good financial health. But they do illustrate how the concept of benchmarking ' setting up statistical guidelines to identify best management practices ' can be a tremendous benefit to law firms. The appropriate statistical benchmarks can identify operating deficiencies in the firm, illustrate where the firm is currently relative to its goals, and provide fact-based information to gain consensus among partners. Financial benchmarking helps law firms measure their business effectiveness by analyzing profitability, cash flow and collections to better assess the value provided to clients and better reflect it in their bills.

Benchmarking Fundamentals

Benchmarking focuses on profitability, reflecting the value creation dynamic of any business enterprise: Profits equal Revenues minus Expenses; in other words, P = R – E. Although this is a simple equation, there are a number of performance factors that underlie it to determine a firm's profitability, including:

• Billing rates, whether hourly, blended (an average), fixed fee or other measure;
• Utilization, the percentage of a workweek (usually expressed as an annual average) that a lawyer actually bills;
• Realization, the amount of time actually billed and collected;
• Leverage, defined as the ratio of non-partners (associates, paralegals, staff) to partners; and
• Expenses, related to both operations and compensation, as a percent of revenues.

Billing rates are important, but should not be over-emphasized. The key to any law firm's performance is realizing the money collected from hours billed. This realization is sometimes discussed in two levels: Billed to billable ratio (the percent of billable or booked hours billed), and collected to billed ration (percent of billed work collected). The goal is to have a high collected-to-billable ratio. An overall realization of less than 85% is a recipe for trouble, because it means the firm has to treat 85% of its billings as 100% of its revenue.

Cash flow is the benchmark that ties these elements together. All organizations, large and small, law firms and non-law firms, have a second thing in common beyond cash flow: the three categories of expenditures for which cash flow is used.

1. Non-discretionary (mandatory) spending that is required by current obligations and by law: debt repayment, insurance, Social Security and federal income tax payments.
2. Adjustable spending that is important but can be modified (such as lease terms and staffing).
3. Discretionary spending that could be eliminated if necessary.

What is unique to law firms is the impact so many individuals have directly on discretionary spending, and thus on cash flow. In many law firms, individual partners can direct discretionary resource consumption. This may involve anything from purchasing new office furniture to charging the firm with personal meals and travel to making a commitment for a firm-sponsored table at a charity dinner. Adjusting the lawyers' compensation to financially appropriate levels, controlling or eliminating individually directed discretionary spending, in accordance with the revenue and expenses of the firm, and keeping debt only for long-term purchases (not for lawyers' draws or pet projects) is the only way to protect cash flow and keep a law firm vibrant and afloat.

Analytical Fundamentals

That brings us back to our original premise: too few lawyers understand these financial dynamics. Admittedly, today's financial information systems and software can ' and do ' produce extremely detailed assessments of financial performance to benchmarks, including the vital tracking of cash flow performance. However, many of these programs tend to provide far more data than can be assimilated intelligently. Some of these tools make the assessment process virtually automatic, and point out major variances for attention. These products can take the raw accounting information from individual firms and compile them with similar accounting information from other law firms. Then, the information can be filtered into quartiles such that all law firms that participate can assess where they are relative to other firms.

But such complexity of data raises the concern of conveying the information so that it is usable. A good analytical analogy can be made to driving a car. All the driver behind the wheel wants to do is glance at the dashboard and see the speed, the efficiency of how the engine is running, and how much fuel is left. This “dashboard” concept can be applied to the benchmarked financial information compiled by software programs, with important financial metrics displayed in an easy to understand visual format for presentation to law firm management. Information on the digital dashboard should be visually appealing, presented either as bar graphs or line charts. It should not try to display too much information on one visual ' no more than the current 12-month trend plus the same month of the prior year is a good reference point. Use longer timeframes where appropriate. A graph of profits per partner, for example, might show five years of results.

The most important goal of creating and evaluating a financial dashboard is to spot problems quickly and adjust the firm's activities so that financials remain positive. The dashboard concept shows that financial benchmarking and analysis needn't involve mastering management jargon or looking at things through the eyes of an MBA. Many lawyers, whose undergraduate and law school training had little practical business focus, think either they can't or shouldn't be business-minded. That is why analysis alone is not enough. Lawyers still must possess the desire and make the fundamental effort to understand what financial benchmarks mean and why they are important. This is nothing less than their moral obligation as owners of the firm. It takes commitment to such an obligation for benchmarking to be effective, no matter how sophisticated or understandable the analytical tools are that the firm uses.

Ed Poll, J.D., M.B.A., CMC, Principal, LawBiz Management, helps law firms increase profitability, coaching them on issues of internal operations, practice development and financial matters. A member of this newsletter's Board of Editors, he can be reached at 800-837-5880, www.lawbiz.com, www.lawbizblog.com and www.lawbizforum.com. Edward Poll ' All rights reserved ' 2013.