Is there a moment each month when, reviewing the latest financial statements from your accounting department, the numbers, the terms, and the dollar signs converge and you think, “What does all this mean? ” Or, if you understand what you see, can you explain it to your non-accounting staff members (or to partners and associates whose talents are not necessarily in finance and accounting)? Understanding – and driving – where the money comes from, where it goes and how your firm monitors, reports and plans finances is crucial for executive directors and administrators.
However, even a legal management professional with an accounting background may not be fluent in the nuances of accounting and finance as it pertains to your firm. While law firms are businesses, the inherent financial concepts taught in financial management and accounting courses may not prepare you for the reality in the firm. “There’s such a big difference in accounting and financial management between other businesses and consulting organizations like law firms,” said Joseph Grasso, associate dean for Finance, Administration and Corporate Relations at Cornell University’s ILR School.
He cites client trusts, firms’ debt needs/philosophy and no traditional “inventory” as areas that vary from the norm. How can administrators ensure they watch the right metrics and shape the correct accounting and financial approach? There are some basic hotspots and insightful areas most effective financial managers and legal administrators monitor – even if their backgrounds include little formal training. “I was an English education major in college,” said Paul Morton, an ALA member and executive director at Burns & Levinson in Boston. “I took accounting after college and dropped it – boring!
I took macro and micro economics. Everything else I learned on the job or at conferences or through reading. ” Morton’s story is reflected in administrator peers across the industry: Administrators and executive directors come to know – through practice and expectation – the important metrics in their organizations. The ebb and flow becomes second nature. “My background of 20 years in Army did not have a whole lot of law firm finance and accounting in the curriculum – I learned more about disassembly and assembly of the M-16,” said Ron Henry, executive director at Wilentz, Goldman & Spitzer (and former ALA president). I learned what I needed to know on the job and through consulting with the firm’s outside accountants as the need arose. I think anyone with analytical skills and common sense can easily pick up what one needs to know. ” So, what does one “need to know” to succeed? There is alignment among the experts (academicians, economists) and the practitioners in law firms: Know where you stand and where you want to be. Watch key metrics. Communicate expectations with partners, staff and your financial institutions. Knowing What Is Important In theory, accounting seems deceptively easy: debits and credits – money in, money out.
Either the firm has money or it does not. “The basic things law firm managers – and their partners – need to remember is that law firms are businesses. As such, they need to be run by business professionals,” said Richard Bank, a former managing partner at what once was the Graham & James Washington, D. C. , office. “Although the final decisions may be made by the partners, it’s the administrators who oversee the daily work. But the bottom line is a simple principle: A law firm is income in, services out. ” However simple this may seem, reality is harsh.
Tax implications, accounting variations and unique situations make law firm finance anything but clear. There are key financial hot buttons that offer administrators and executive directors ready insight to the firm’s standing – and it is these areas where administrators (seasoned or not) will glean the best intelligence for running their organizations. Just as accounting can be overly simplified, Ron Henry simplifies the driver for law firms: Partners want to know they are going to make at the end of the year. Approaching law firm finance from this perspective actually gives administrators a clear starting point.
It helps identify the key metrics that reveal cash flow, help drive lending (should it be needed), and ultimately lead to payouts. “My managing partner, CFO and I monitor the financial position on a daily basis, or close to it. We track the key performance indicators – production/billable hours, billings, collections, realizations, write-offs – very carefully on an individual, practice group and firmwide basis,” Morton said. He added that monitoring the expense position very carefully, especially compared to the approved budget and against historic figures in the same area, allows for very accurate projections. The managing partner tends to focus more on billing and collections activities and I tend to focus on expenses, productivity and cash flow. ” Henry takes much the same approach: “We watch current performance and budget as it relates to last year’s,” he said. The firm is then able to extrapolate from the trending data exactly where the firm is performing to expectations and where it is not. “You figure out the expenses you’ve had in detail,” he said. “You watch your fee receipts. Watch current performance against budget as it relates to last year’s performance.
You figure out where your fees should be and you adjust accordingly. ” Henry said that Wilentz, Goldman & Spitzer looks at three years’ history to assess revenue needs and projections. And to help monitor the current year’s progress, Henry produces reports that measure cash flow by month over a 13-month period. Grasso agrees that compensation of partners is a driving issue: “How does the distribution of profits or losses affect the tax liabilities of individual partners as well as the partnership” he said. All of these metrics and reports fit into what Grasso sees as an overall perspective law firm managers need to grasp. I always like to use ratios to measure my firm against another firm,” he said. “Some of these ratios are more operational than financial, but they provide good insights into how productive and efficient the firm is. ” He cites key ratios of gross revenues per employee; attorney to support staff; and fixed costs to total costs as ones to watch. (See sidebar. ) The Law Firm Way Former managing partner Richard Bank touts the important role law firm managers play in the business success. “Law schools don’t teach management. They don’t tell you that you can expect to collect only 85 percent of what you bill.
If you have unrealistic expectations, your billables may be too far gone before your realize their effect on the bottom line. In fact, because of timing and history, it could take as long as two years to uncover what’s happening. ” Understanding the unique way a firm functions is key to the administrator’s success – at keeping the firm on the right track and at helping firm decision makers understand the cause-and-effect relationship of their actions. “Our monthly financial package is prepared by our CFO and his staff,” Morton said. I often conduct analyses or raise questions addressed by the staff. We take turns presenting at the partnership meetings – sometimes the managing partner presents the numbers in summary fashion, sometimes our CFO does and sometimes I do. ” From this information, Morton and his team develop and prepare the year-end analytical reports that are used by the firm’s Allocations (Compensation) Committee. As compensation remains the driver, Morton participates in all the compensation meetings and works to help the partners understand the data.
Throughout the year, he works with associates to help them understand their individual production and how their progress compares with firm expectations. Morton believes sharing financial information is a key driver to a more profitable firm. He quotes the adage heralded by an off-price clothing store founder, “An educated consumer is our best customer. ” “The same is true in law firms. The more people understand why you need to behave in a certain way the more likely they are to be motivated to perform that way,” Morton said. If they understand the dynamics of the financials then they can understand why you are pushing them to behave in certain ways. ” Effective administrator-financial managers play a key role in shaping future firm leaders, Morton said. Managers can start modifying behavior at an early age with associates. “By the time they become partners the appropriate behaviors will be ingrained. If partners understand the financial dynamics then they can understand the drivers that make the firm run and can try to perform accordingly. ” Morton is not alone in this philosophy: “Personally, the more information you share, the better.
This gets everyone to have skin in the game,” Henry added. Sage Advice Where should a law firm manager with no formal accounting and finance background begin? These seasoned experts share their thoughts: •Financial Statements “When I took my first legal administrator position – not my current position – I learned how to read financial statements; how to understand balance sheets; and how tax issues impact everything,” Morton said. •Key Concepts Working capital and cash flow are two extremely important terms for any legal administrator. Other terms and concepts to consider are assessed receivables reports that measure how quickly your clients are paying you,” Grasso said. “Sometimes when assessed receivables rise, it is a good thing: It could mean that your business is growing. On the other hand, as assessed receivable balances rise, it could mean that the economy is weakening and the firm’s clients are not able to pay their bills on a timely basis. ” •Banking Relationships/IRS Banks have become much more cautious in their lending practices and are demanding better financial ratios, collateral, and shorter term/callable loans.
The importance of all this is that firms need to manage their cash resources in a more careful manner and hold larger cash balances,” Grasso said. “There is likely a tension in many law firms about how much to distribute to partners versus retain in the business. But in an economic downturn, cash is still king and is needed to survive difficult times. ” Henry concurs: “Banking relationships have tightened a bit. ” But he finds another institution’s changing expectations affecting the firm more directly. “Managers need to figure out what is depreciable and what must be expensed,” he said. The U. S. Internal Revenue Service is juggling depreciation rules. A lot of rules are changing annually. That’s when we turn to an outside expert to help us know the maximum we can do – and the minimum. ” •Partner Migration Another, more subtle factor is weighing on a firm’s profits and continuity: “Before the 1980s, partners were loyal to their firms – they were there for life,” Bank said. But things changed in the late ’80s: Partners sought greener pastures. “What’s happening at law firms now is very much the equivalent of free agency in professional baseball.
A partner will leave with clients and associates and put up shop at a different firm if the opportunity is right. It’s the Albert Pujols syndrome in the legal industry. ” The Bottom Line What can the non-financial financial manager do? “Law firm managers need to pay attention. They play a key role,” Bank said. “A busy firm does not automatically translate into a successful firm. It comes down to effective management. Help your partners and associates see the big picture. Build relationships with your clients and with your financial institutions. ”
Jay Strother, a former Legal Management editor, is a regular contributor. He was happy to find other English and arts majors whose careers challenged them to learn finance and accounting on the job. Reach him at [email protected] com or via LinkedIn. **** Sidebar ***** What the Experts Say You MUST Know While the fundamentals that drive firm finance are clear (profitability expectations; accounting practices), there are some concepts and that accounting/finance experts say are key to success – even if some of these are the most difficult to grasp? Billing: “A basic concept is the idea that if you don’t send out a bill you won’t get paid, and if the firm doesn’t get paid then the partners don’t make any money,” law firm executive director Paul Morton said. “It’s surprising how many attorneys lose sight of this. ” “Law firm managers need to make sure bills go out on time,” former managing partner Richard Bank added. And to do that, logically, attorneys need to enter their time regularly and accurately. Then, if the firm format bills in the ways that clients want them, realization improves.
The longer unpaid invoice linger, the less likely they are to be paid,” Bank said. “Collect monthly. If a client is not paying, the business manager needs to find out why they’re not paying the bill. And this needs to be done swiftly. ” • EBITA EBITA (earnings before interest, taxes and amortization) is a fundamental measure of operating profits. If a firm’s EBITA is not positive, it needs to examine its revenue streams and cost structures. “Equity partners and banks will review EBITA to determine the financial health of the law firm’s operations,” Grasso said. This may fluctuate on a seasonal basis for some firms, or it may be lumpy when the firm wins a large case or has a dearth of settlements for some period of time. ” Grasso suggests law firm executive directors or managers review EBITA along with the current ratio to keep their pulse on the financial heartbeat of the firm. •Quick Ratios While broad-based financial information offers administrators and managers a big picture of a firm’s trajectory, key ratios – that are quick to calculate – offer telling snapshots of overall performance and expectations.
Cornell professor Joseph Grasso cited some telling numbers administrators should know how to crunch: oLiquidity ratio: Current assets divided by current liabilities reveals this key number. This represents how much working capital the law firm has to operate the business. oDebt-to-equity ratio: “Another balance sheet ratio that is important is the debt-to-equity ratio,” Grasso said. This allows you to better understand the financial structure of the firm: How much debt does the partnership carry in relationship to its equity? This is important because the business manager needs to be aware of how highly leveraged the firm is. The debt-to-equity ratio is a key ratio [banks] will examine. ” “To have any ratios and statistics be meaningful to managing partners, the business manager should track these statistics over time to show how cash flow has been managed in the past, both in good times and in bad,” Grasso said. “This type of trend analysis is critical so that the numbers can be placed I the context of the lifecycle of the law firm. ” •Client Trust Accounting
Some law firm accounting practices are unique to professional service organizations. A major practice in law firms is creating a client trust account. “This is a fundamental and critical aspect of a law firm business manager’s job,” Grasso said. He cautions administrators to ensure they are not counting or including trust funds and escrow accounts in the firm’s income statement or balance sheets when preparing their monthly, quarterly, or annual reports. “This seems like obvious advice, but we all know of firms and lawyers who, in difficult business times, have relied on escrowed funds for cash-flow purposes,” he said. You need to make sure your firm has the proper accounts established with your bank to ensure there is a clear segregation of funds and proper sign offs by the firm’s management structure. ” •Know Your IT One financial management area may not first seem like it belongs: Your firm’s technology infrastructure affects how it handles money and produces reports. “Law firm managers must know their IT. So much of a firm’s accounting process and billing are directly impacted by technology,” Bank said. “To be effective, you must be tech savvy. ”