Cash is reality when it comes to law firm success

After two years of COVID-19, life for many was starting to return to some form of normality, but in just a short period of time global energy and food prices have put paid to that hope.

High inflation has returned, putting a whole new series of pressures on legal firms as they try to keep up with ever-increasing costs and which their accountancy firms should take into consideration.

For many of your legal sector clients, the new financial reality signals a renewed focus on careful cashflow management. Whilst the sector was not exactly awash with cash during the pandemic, a combination of Government lending schemes providing cheap debt, furlough and a softening of requirements for partners’ tax payments certainly helped liquidity. 

At Iceberg, we have seen a recent increase in the number of enquiries from legal firms relating to borrowing requirements linked to cashflow management as normal market conditions started to return. As the old saying goes, ‘cash is reality’.

Cashflow issues have historically been a significant contributory factor in law firm failures. As profits are distributed to partners, and it is more tax efficient not to hold capital within the business, most law firms operate with a low level of cash.

Law firms’ main costs centre on rent, salaries and PI insurance, all of which must be paid on a monthly or quarterly basis.

Other liquidity challenges relate to the nature of legal work. Lock-up, the combination of unbilled work in progress and outstanding accounts, is a drain on working capital. According to various studies, law firms average between 110-140 days’ worth of earnings sitting in lock-up.

It’s an issue that many law firms wrestle with on a monthly basis and cashflow issues can impact smaller firms in particular as they do not necessarily have the breadth of resource to call upon.

There are some simple steps that businesses can take to more effectively manage cashflow.

Being fully aware of cashflow bumps in the road is the most effective way to mitigate and plan for issues. We advise clients to prepare a cashflow forecast for a minimum of 12 months ahead to assess where cashflow issues are likely to occur. We also advocate the use of a rolling three-month forecast for more accurate micro-management of cashflow.

Law firms have many funding options open to them to cover cashflow and other costs, such as overdrafts, bank loans and specialist legal sector funders, such as Iceberg.

One specific area to consider is the time to pay arrangements with HM Revenue & Customs (HMRC) for your deferred VAT liabilities. Meeting the cost of VAT each quarter, particularly when payment relates, in part, to unpaid fee notes can put a real strain on cashflow.

A VAT loan account is an option that enables the law firm to spread the cost over three-monthly payments. This type of facility can be taken out to supplement other types of borrowing and payment can be made directly to HMRC from the lender on the law firm’s behalf.

Billing discipline and hygiene is central to healthy cashflow management. It is recommended that firms bill on at least a monthly, or sometimes weekly, basis, where possible. Firms should also make sure they bill before the month end as this increases the chances of being included in an early pay-run, boosting cashflow.

The number of lock-up days should be considered a key performance indicator of any legal firm.

At a time of rising costs – from salaries to energy – it’s important that law firms maintain overhead discipline. Annual audits of all costs should weed out those overheads that aren’t important to the business.

One of the biggest costs for legal firms is rent and, with the move to hybrid working, firms should consider whether their premises are the right size for the modern workplace. Can costs be saved through more remote working or shared office space, for example?

A PwC report from last year found that 48% of the top 100 law firms plan to reduce their office footprint in the short-to-medium term and I’m sure that is a trend that will be repeated across the country and will be a feature of many of your clients’ financial considerations in the time ahead.

^{*The views expressed are the author’s and not ICAEW’s.}

^{About the author:}

^{Michael Stevenson is a Chartered Accountant and worked for many years as an Insolvency Practitioner, predominantly for Smith & Williamson, now Evelyn Partners. Since 2009, he has been instrumental in the setting up and managing of the Iceberg business, which provides working capital loans to UK law firms. Since 2017, Iceberg has been part of the Paragon Banking Group.}