How Much Capital is Enough? How to Assess Your Firm’s Need for Capital
Kalman Shiner, CPA
Does your firm have a sufficient amount of capital to support its daily operations? Do you know how to determine how much is enough? To offset gaps in cash flow due to expenses, law firm billing and collections, law firms may require larger partner capital contributions. Having a capital plan in place will help with the uncertainty and provide partners and other stakeholders with a sense of stability.
What are your expenses?
All firms face financial pressure. For example, your firm may have to provide client cost advances during lengthy litigation. And, while the economy is holding steady for now, it is not unusual for clients to drag their feet when settling bills. Regardless, outside vendors expect prompt payment. Your firm might not have invoiced a client before vendors demand payment.
In addition, growing firms must hire new associates and lateral hires. Even lateral hires who bring clients with them usually receive several paychecks and incur overhead costs before those clients start generating — and paying — additional revenues. Partners also are expensive. As more Baby Boomers approach retirement age, some firms have more partners leaving to retire than young partners buying in.
Finally, today’s attorneys expect to work with sophisticated hardware and software and clients expect their attorneys to leverage technology to provide efficient, cost-effective services. Keeping up with rapidly changing technology — and technologically up-to-date competitors — can be expensive.
Do you have a plan?
All of these issues can be alleviated with adequate capital reserves. If revenues fall short, your firm can tap into its capital to bridge the gaps. Having a capital plan can be helpful in these situations.
Your plan should address the firm’s capital needs for the next three to five years. To quantify those needs, consider your average revenue cycle, any anticipated capital investments (for example, technology or physical space), operating expenses, estimated client disbursements and perhaps partner draws (although it is usually best to defer draws, rather than paying them out of capital). If applicable, your firm should take into account any payment obligations to retired partners.
What are some options?
Once you have calculated your capital needs, you have four basic options for determining the specific amount of capital your firm needs to keep on hand. You might base capital needs on one or more of the following:
- Monthly Expenses (Not Including Partner Draws)
If your firm has a strong cash flow (meaning prompt collections), you might set capital at one to two months. If you have a slower turnaround, you may need to use three to six months as the measure.
- Fixed Percentage of Gross Fee Collections
When setting the percentage, assess the timeliness of your collections and plans regarding hiring and space. Most firms set the percentage close to 10%.
- Long-Term Debt
Putting aside capital equal to half of your firm’s long-term debt provides lenders with some comfort. Since the 2008 recession, lenders have been less accommodating about extending credit to law firms than they were in the past.
- Net Fixed Assets
This method assumes that your firm has secured outside loans to finance fixed assets and that your partners will fund working capital in an equal amount.
When you have settled on the appropriate capital level, decide on the proper breakdown between partner contributions and lines of credit. This decision should take into account your firm’s — and individual partners’ — tolerance for debt. The higher the debt tolerance, the greater you can rely on credit lines over contributions and vice versa. Note that your partners should also consider potential personal liability associated with lines of credit. Credit lines typically are subject to joint and several liability, putting all of your firm’s partners at risk of liability for the entire amount owed in the event of default.
Remember that reviewing your capital plan is not a one and done. Be sure to review your firm’s capital plan regularly (at least annually) to keep pace with your firm’s strategic and financial needs. Make adjustments, if needed, and communicate any updates to your firm’s partners and other stakeholders.
Five Tips for Managing and Improving Your Firm’s Cash Flow
Joel Herman, CPA
While many law firms monitor profitability, some firms can overlook the critical role that cash flow plays in both day-to-day operations and long-term sustainability. Focusing on billable hours and production targets are imperative, but law firms cannot generate revenue if they do not have sufficient cash to keep the doors open. The following practices can enhance cash flow to help position your firm for success and growth.
- Plan Properly
Effective cash flow management begins with comprehensive budgeting. Ample time, thought and research should go into the budgeting process. Budgets should include the trivial details of day-to-day operations, such as expenses for photocopying, postage and office supplies, along with projections for special initiatives, such as marketing and recruiting programs, enhancements to the firm’s technology infrastructure and improvements to the office premises. By preparing a detailed and thorough budget, you can provide firm management with a better picture of how such costs affect cash flow.
When reviewing your monthly financial statements, also compare the actual results to the budgeted expectations for fluctuations. Prepare monthly, quarterly and annual cash flow projections. Forecasting can make it easier to identify and plan for slow periods and other trends.
- Bill Accurately, Clearly and Timely
Timely billing, periodically as the engagement is progressing or immediately after it is resolved, is the cornerstone of cash flow. Clear and accurate billing is essential, as disputed charges often delay payment.
To increase the likelihood of on-time payment, ensure that your invoices describe the services rendered in a manner easily understood by clients. If invoices are not clear as to the services provided, clients may become frustrated and set the bills aside. Each invoice should noticeably highlight the due date and the amount due.
The sooner you bill, the sooner the cash will be collected. Clients often devalue services received as time passes, so invoices should be sent shortly after services are rendered. Prompt billing implicitly suggests to clients that you expect to be paid promptly. Consider electronic billing to speed the process.
- Reassess Your Handling of Client Expenses
Many firms initially cover substantial portions of their clients’ expenses out of their own funds, leading to long lags in out-of-pocket costs and, as time passes, the increased possibility of clients failing to reimburse for these items. If clients do not pay for their actual timely costs, overhead can explode and drain a firm’s resources.
Account for reimbursable costs, direct expenses and other overhead expenses in your billing system. To avoid making clients feel like they are being “nickel-and-dimed,” consider incorporating charges for some overhead items, such as postage and copies, as a surcharge to your hourly rate.
- Take Steps to Encourage Timely Payment
Help your clients help you. If sending invoices electronically, create a link for online payment. Encourage your clients to set up automatic payments by EFT or wire transfer.
You also might consider offering clients incentive discounts for early payment or consider accepting credit card payments. With discounts, though, it is important to monitor and make sure they are only allowable for immediate payment. Once clients are delinquent, discounting their bills can encourage them to continue to delay payment of their invoices. Consumers do love accumulating credit card points for free travel and other benefits. Credit card processing does come with a merchant processing cost, but that can be eliminated by including a convenience fee for each credit card payment processed.
- Develop a Formal Collection Plan
Regardless of firm size, collections should never be handled on an ad hoc basis. Have a formal plan that lays out the steps you will pursue when clients miss their payment deadlines. The plan should address:
- When and how follow-up is performed;
- The number of days past due that is deemed delinquency; and
- How delinquencies will be addressed.
For example, the plan could dictate that you will send a new statement as soon as the initial statement is more than 30 days outstanding. Additional follow-ups will go out at 60 and 90 days, perhaps with a phone call or handwritten note from the billing attorney. Frequent communication with delinquent clients is a crucial component in the collection process — and you can automate this communication to make it easier to manage and consistent across all clients.
Consider imposing late fees or a temporary suspension of services at a certain point. If you opt to go this route, though, warn clients of these policies in advance to avoid disgruntled feelings.
Stay on it
Effective cash flow management is an ongoing process. Regularly scrutinize your cash flow statements to identify trends and key performance indicators for cash flow (for example, average days outstanding in work in process or accounts receivable) and adjust your practices accordingly.
Sidebar: Get the partners involved
It is not enough for partners to accurately track their own time; they also must assist in prompting their clients to pay in a timely manner. To help partners do so, provide them regular reports on outstanding invoices by month, collection efforts to date and an aging of unbilled fees.
Set standards or a threshold for unbilled fees. When unbilled fees exceed the threshold or a time period, management should intervene, whether by urging the billing attorney to address the situation or by management handling the client billing directly.
Seek the partners’ input on the best time to convert their clients’ billings into realized fees — that is, when the clients are at peak satisfaction. Your partners should be expected to alert the billing staff when, for example, they or their associates have finished drafting a complicated contract, completed a transaction or secured a favorable ruling in litigation, whether on a motion or the ultimate verdict. Clients are more likely to quickly pay their bills in the wake of positive outcomes.