“I don’t understand why my firm is profitable and yet we always seem to be up against it with the Bank. We don’t want to be putting in more capital this year so what can we do now to get a grip on this?”
Ultimately all a firm’s cash is generated from its fee income in the form of its retained profit, ie. after paying fee earner salaries and overheads (and drawings in the case of a partnership or LLP). So why should a profitable firm struggle with cash?
There are two main reasons:
First, it’s to do with the timing of receipts and payments – you aren’t getting the money in quickly enough.
Secondly, it’s to do with a weak profit compared to the liabilities on the balance sheet – you are not making enough money to both pay our debts and earn what you want from the firm.
Problem one – Timing
The timing problem is that income is earned well before the cash relating to that income is received by the firm. In the worst case, you could have all your income in the profit and loss account but not received any cash at all.
The biggest number in the firm’s Profit & Loss account is – hopefully – its income. ‘Income’ in most managing partners’ eyes is ‘Fees billed’ or ‘Costs’, as some still refer to them. In truth it is incorrect to think of the fees billed as the firm’s income. Sadly, we accountants have muddled the issue and a firm’s income is no longer generated when the fees are billed. Income is generated before the bills are raised. Income is created when the work is done, (and there is a contractual right to receive payment).
Every firm should have a method of calculating its income based on the work done to date and not rely on the fees billed. You might rely on adjusted Work in Progress figures, for example – but I shall come back to that topic in more detail, another day.
When a fee earner starts work on a matter, they start to create some value for the client – but that value may be turned into a bill for the client many months later. It will, almost certainly, not be billed on day one.
A month passes and they have undertaken more work and created more value – say 10 hours’ worth (£2,500) – but the matter is agreed to be billed when it is finished, so it is not yet billed.
Another month passes and another five hours’ work has been done, so another £1,250 of value to the client has been created – but it’s still not finished, so it’s not yet billed.
Eventually, after adding another five hours, the matter is finished and at the end of the month, the matter is billed for the total £5,000.
Our timeline, with the cumulative income generated, looks like this:
At the end of Month 3, the bill has gone out but still no cash has been received. If ‘Month 3’ in the example above was also Year End, you would have £5,000 of income – but no cash. Indeed, if Month 1 was Year End, you would have £2,500 of income and no cash and likewise if Month 2 was Year End, you would have £3,750 of income – and no cash.
You are likely to receive the cash in due course – but all the time you are waiting for your money, you are paying your staff out and paying your overheads, as well as repaying any borrowings etc, so you are out of pocket and in this simple example, you would have to run at an overdraft until fees are received.
The solution lies in billing work much faster and/or collecting money in advance.
By billing at the end of each month and insisting on payment of each bill before continuing with the work, you reduce the amount of unbilled income.
Furthermore, if you obtain payment in advance, then you can never be out of pocket and money will be available, often in a Client to Office transfer, to pay the bill as soon as it is raised. Obviously, it can be difficult to estimate the value of a matter in advance but if you agree a fixed fee, that makes the job a bit easier.
The whole issue of obtaining payment in advance seems difficult for some lawyers: but many firms now operate on this basis and they do not suffer from cashflow difficulties or bad debts.
Problem two – Weak profits and high liabilities
A firm’s profits are generated to provide an income to the owners: but there is a prior call on the cash generated, which is to pay off any borrowings that the firm has.
The amount taken to repay those borrowings, (and this can include short-term items, such as PII being paid on instalments as well as bank loans), then reduces the amount available to the business and ultimately to the owners. It is important that the firm does not allow itself to borrow too much, leaving itself unable to both repay the borrowings and provide a satisfactory income to its owners.
It is critical in a business with high borrowings that the profitability remains high. Otherwise, if profits fall, too much of the profit is taken with repaying the borrowings and too little is left for the owners as profit and to re-invest in the business.
One way of looking at this is to see the ‘free cash’ at the end of an accounting year. This is not quite the same thing as having a cashflow forecast for the year, which shows the peaks and troughs and can be adjusted to reflect different rates of income but it is a simpler way of looking at the issue.
In the example below, Income in Year 2 is 10% less than in Year 1. Net profit falls in consequence by 30% but the amount available to the owners, after making its borrowing repayments that year, falls by 40%!
|Year 1||Change||Year 2|
|Profit before tax||3,500||(30)%||2,500|
|Available to Owners||1,950||(40)%||1,250|
I shall leave you to work out in detail what would happen if Income fell by another 5% but I will tell you that the amount available to the owners falls by another 25%.
Small changes in income have a large impact on the cash available. Therefore, it is wise to be cautious about borrowing and we should continue to strive to be profitable.
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