Knowledge is critical to good decision-making. That is why law firms should arm their partners with the financial information that will enable them to identify and address cash shortfalls and other problems before it is too late.

Three Categories

Your firm’s income statement and balance sheet contain most of the numbers you will find in a cash flow statement. However, a cash flow statement also provides information about receipts and disbursements — information that is essential to preventing liquidity problems.

A typical cash flow statement is divided into three sections:

1. Operating Activities — These numbers reflect your firm’s operating activities and liquidity and can be used to identify revenue and earnings declines. If the amounts of your net income and operating activities are similar, your practice is probably healthy. It is also generally a positive sign to experience close growth rates for net income and operating cash. However, be aware of when cash lags behind net income growth. Even if your firm’s income statement shows that earnings are growing in double-digit percentages, flat cash collections should be scrutinized. Also, keep an eye on growing accounts payable. An issue may exist if your firm routinely delays payments to vendors because it lacks cash.
2. Investing Activities — The data in this section accounts for your firm’s purchase and sale of property and equipment. Firms typically use cash to invest in technology and office machines. But investing activities may also cover lending by your firm and subsequent collection, as well as the sales and purchases of long-term securities.
3. Financing Activities — The last section of your cash flow statement illustrates the firm’s financing that is not used for daily operations. The largest cash outflow here is likely to be distributions to partners. However, the section might also include loans from banks and other lenders, as well as capital contributions provided by partners. If your firm is growing quickly, consuming more cash than you generate may be appropriate. And if your firm has substantial debt, repayments will affect cash available for distribution.

Taking Action

Your firm may be focused on other profitable efforts, causing you to neglect cash flow. If you are concerned about liquidity after reading the firm’s most recent cash flow statement, take action.

Your partners should discuss and document policies that will fix current shortfalls and prevent future cash flow problems. For example, you might decide to:

• Bill clients more regularly to minimize unbilled work in progress;
• Implement tighter accounts receivable controls;
• Pay bills on time, but not before their due date; and
• Time purchases to control variable expenses, avoiding major expenses during low cash flow periods.

If inadequate revenue is an issue, consider placing more clients on retainer and increasing existing clients’ retainers. Or, you might raise your hourly rates. Raising rates in installments (say 5% in January and 5% again in July) can make higher rates easier for clients to process.

You should also monitor your firm’s cash flow more carefully and frequently, perhaps on a weekly basis. Also, regularly compare actual cash flows with the budgeted amounts and work to reconcile any variance.

Avoid Cash Crunches

Cash flow statements serve as your firm’s early warning system. To avoid an embarrassing and possibly crippling cash crunch, distribute these statements to partners at least monthly.

What should you do if your cash flow statement indicates that you may have a liquidity problem? Contact your financial advisor to discuss possible solutions and to put in place policies that will prevent future cash crises.

For more information on cash flow statements, contact Rob Swenson at [email protected], or call him at 312.670.7444. Visit ORBA.com to learn more about our Law Firms and Lawyers Group.