How to Benchmark Your Law Firm’s Financial Performance

21 septembre 2014
Edward Poll

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The idea of benchmarking – setting up statistical guidelines to identify best management practices – has long been used in industry, and it can also apply to law and professional service firms. The appropriate statistical benchmarks can help you:

explore operating deficiencies in the law firm;
understand where you are currently relative to your goals, and;
provide fact-based information to gain consensus among your colleagues.

For the typical small or mid-sized law firm the most important benefit of benchmarking is to measure your progress toward achieving your goals and strategies. The performance standards to which other organizations aspire can give you a target. But they are of little help if you don’t use them in accordance with your firm's culture, the capabilities of your personnel, and your aspirations.

Business Competency

Your firm cannot aspire to achieve your benchmarks unless you understand the operation of the firm as a business (budget, collections, profit, loss), the firm’s billing structure, how each attorney determines firm profitability, and the importance of clients and their own businesses. Years ago, I registered the phrase, “The Business of Law®,” because it summarizes this foundation of benchmarking. When I've seen the "numbers presentation" at too many firm meetings, it generally is abstract and pro forma.

How many lawyers, even partners, would possess the business competency to calculate, or even understand, the traditional key measures of law firm performance: realization, utilization, leverage and expenses? How many know, or understand, the firm’s collection rate – or their own personal one? Lawyers must possess that kind of business competency for benchmarking to be meaningful.

Performance Factors

Benchmarking focuses on profitability. In the simplest of terms, profit can be determined by taking the total annual gross revenue by client and subtracting the costs associated with serving that client, including how long the firm has to wait for the payments. A number of performance factors 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 and realization percentage are key markers of any firm’s financial strength. Look at your standard rates and any alternatives you use. Are you able to bill premium rates? Must you frequently offer discounts? How do your rates compare to those of your competitors? The answers to such benchmarking can be revealing.

Realization Rates

Billing rates are important, but don’t overemphasize them. The key to any law firm’s performance is integrating how many hours you bill with how much money you collect. This realization is sometimes discussed in two levels: Billed to billable ratio (the percent of billable or booked hours billed), and collected to billed ratio (percent of billed work collected. The goal is to have a high collected to billable ratio.

An overall financial ratio of less than 80 to 85% is a recipe for trouble. An overall ratio of greater than 95% may mean your rates are too low – clients could be paying quickly because the amounts are not burdensome to them.

Revenue, especially for a small practice, can be variable. A good method for estimating revenue and when you will receive it is the accounting measure of turnover ratio: accounts receivable balance divided by the result of billings per days in the billing period (either monthly or annually). The turnover ratio tells a lawyer to expect payment for billings X number of days after a client receives a statement.

The average for law firms, according to one survey, is between 120 and 150 days—as much as five months. That means that a typical firm should have funds sufficient to operate for at least six months without new billings coming in. But no firm should ever let things reach that point. Collecting the money that clients owe you should be your first financial priority.

Cash Flow

Most lawyers realize that they are in financial trouble only after the money ceases to come in the door. However, cash flow cessation is usually the last symptom of a downward spiral that started long before. That is why the development of a cash flow statement is essential. Prepare a forward-looking budget of cash receipts and payments for the next 12 months. Keep that statement on a rolling 12-month cycle such that as you conclude the current month, you look at the 12th month and add it into your budget, adjusting all the other months if needed based on new information.

This process directly relates back to collections. Keep your accounts receivable listing always at your elbow to make sure that your clients are paying you in accordance with their agreement. It is vitally important that you move quickly to collect any overdue accounts.

One study shows that a bill over 60 days past due can still be collected about 89 per cent of the time. However, that drops to a 67 per cent likelihood of collection after six months, and to a 45 per cent likelihood after one year.

You truly have a good relationship with your client only when the client's account receivable is up to date. Delinquent accounts indicate that the client doesn’t respect you, is attempting to hoodwink or undercut you, or is dissatisfied and possibly considering disciplinary action against you.

Profit and Loss

If you’ve properly managed cash flow and collections, you will have a profit to tally up. Income statements, also called profit and loss or P&L statements, tell how well a firm performed financially during a given period of time. Income statements using the accrual method tell how much revenue has been billed, how much expense has been accrued, and how much net income or profit resulted.

Income or profit figures generally have little relevance to small law firms. Small professional service firms typically operate on a cash basis, with the lawyer’s salary or draw coming from positive cash flow. Financial analysis for the small firm is a process of identifying and deducting the expenses of the practice (staff, rent, taxes, professional services) from monthly cash received, and drawing compensation from the balance.

Improved Practice

The kind of financial benchmarking and analysis we have discussed doesn’t involve mastering management jargon or looking at things though the eyes of an M.B.A. Many lawyers, whose undergraduate and law school training had little practical business focus, think either they can’t or shouldn’t be business-minded.

In fact, a business focus improves the practice of law. Lawyers who understand financial benchmarking can better assess the value they provide to clients, and better reflect the value of the service in their bills. They begin to think in terms of anticipated travel, staffing plans, strategies for effective structuring of discovery. They develop an appreciation of those areas where costs can be controlled and where costs are inherent. In short, they do a better job for their clients—and that’s what the practice of law is all about.