The Financially Healthy Law Firm
by Barbara Lewis and Dan Otto
(County Bar Update, November 2002, Vol. 22, No. 10)

The Financially Healthy Law Firm

By Barbara Lewis, M.B.A., Law Practice Management Section Executive Committee, and Dan Otto, M.B.A. Lewis and Otto are partners with Centurion Consulting Group, which provides financial, marketing, and operations consulting for law firms. They can be reached through their Web site at www.centurionconsultinglaw.com. The opinions expressed are their own.

As we head into the end of the year, now is a good time to assess your revenues, expenses, and profits for this year and develop your projections for next year. The one-third mantra is the rule of thumb -- one-third of revenues goes to overhead, one-third is for salary, and one-third is profit. Although research indicates that average law firm profits are 33 percent prior to partner draw, an efficient and well-run law firm can generate substantially more.

In gauging the health of your firm, the financials are the first place to start. Year-end statistics can give you a benchmark for next year’s financial goals. If you have financials from previous years, you can easily ascertain the financial trends in your firm. The four basic areas to analyze are revenues, salaries and other expenses, profit (partner draw), and accounts receivable.

Oftentimes, attorneys pursue revenues only to get caught in a situation where expenses increase and profits sink. That new client who peppers the staff with questions and requires handholding that cannot be recouped through billing eats away at the profits. One hundred small clients who need files opened, database fields filled in, and billing information entered generate less profit margin than one large client with the same total revenues, due to the unbillable administrative tasks.

Another area where attorneys fall victim is increasing expenses. The percentage rise in expenses should be less than the percentage increase in revenue. Yet, when firms grow, they are quick to hire additional people, the largest component of expenses. Rarely do employees tell partners that they don’t have enough work, but they are quick to point out when the work increases. The result is that partners hire unnecessary employees when the current ones could have handled more work after implementing some operating efficiencies.

Accounts receivable is a critical barometer for a healthy firm. Calculating the average number of collection days gives you a benchmark for future monitoring. To determine the average number of days it takes you to collect on your invoices, calculate your total outstanding accounts receivable (less current A/R) and divide by current month’s billings (or a 12-month average billings), and then multiply that amount by 30.

A high number of collection days indicates that the firm is "loaning" money to its clients who are not paying in a timely manner. Keeping collections under 45 days is healthy. The goal should be to continually drive down this figure. By tracking this amount and using easy-to-view graphs, such as Excel, you can monitor your progress in achieving your goal. If the average collection-day amount is more than 45 days, consider hiring a collection person. Most attorneys don’t want to call their clients for monies due, and the result is that collections oftentimes are delayed. Physicians don’t dun their patients for fees, and neither should attorneys.

The most important financial metric is profit and profit margin. To calculate the profit margin, subtract expenses from revenues and divide by revenues. This amount is the profit margin percentage. If you are below 33 percent, you need to take a hard look at your operations.

One way to increase profits and margins is to cut expenses. Each line item of expenses should be reviewed to ensure that the expense is a necessary expenditure that cannot be eliminated. Compare your expenses to the average expenses of law firms your size. For example, your rent should be only 10 percent of your expenses for the average law firm. Expenses that may be above average include delivery services, dues and subscriptions, and supplies.

If you haven’t already established financial benchmarks, use 2002 statistics as the standard. Then develop revenue and profit projections, and an expense budget with financial goals for 2003. Monitor the goals each month to ensure that the health of your law firm is excellent.

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