Key financial stability measures in law firms

The financial stability and ongoing success of any law firm is only possible with high quality, timely financial information that is well understood and acted upon. In this article, we will explore the key financial stability measures in a law firm and explain how to identify the early signs of a firm experiencing financial difficulties.

Given the unique financial model of most law firms, KPIs and benchmarking are vital diagnostic tools used by accountants and owners to help them understand the underlying financial health, sustainability and operational performance of the firm. Used effectively, these indicators allow firms to detect problems at a much earlier stage.

A common measure for law firms' profitability is PEP and this is usually considered to be the headline profitability indicator, as it measures the profit attributable to equity partners/owners.

PEP is often the KPI the owners focus on most and is widely used for benchmarking, however, a firm could have high PEP but, if there is poor cash conversion, it could still be financially unstable, so it is not a foolproof indicator on its own. PEP should not be looked at in isolation and needs to be compared against other trends in lock-up, margin, etc. to assess overall financial performance.

Monitoring PEP trends over time is useful and firms will want to see growth in their PEP year-on-year but understanding how the growth has been achieved is equally if not more important. If it is driven by rapid reductions in staff numbers, or under-investment, this could be a warning sign. Also, decreasing PEP needs to be understood as it initially raises alarm bells and indicates declining profitability. However, a short-term decrease in PEP during a period when there are partner changes (so maybe new partners coming in while the retiring partner is still in place and handing over responsibility) or investment in people, technology or property is expected and does not necessarily indicate an actual long-term reduction in profitability.

Given the high levels of client interest many firms have received over recent years, the quality of PEP should also be considered. Separating trading PEP (PEP excluding interest profit) from total PEP helps firms understand whether profitability remains sustainable if interest rates fall or access to client interest is restricted, which is particularly relevant given the current MoJ consultation.

It is worth reviewing the structure (gearing) of the firm when looking at PEP. Gearing compares the number of equity owners in the firm with the number of employed fee earners. This is important to consider in terms of generating PEP, as more employees charging clients at more than their salary with comparatively fewer ‘equity owners’ to share profits will generally result in better PEP.

Employee costs as a percentage of fees are a helpful indicator of the core profitability (profit margins) of a law firm. However, employee costs in isolation can be misleading as they do not consider the costs of the self-employed owners of the firm who also contribute to the productive capacity of a firm. Notional salaries for owners need to be included to arrive at total people costs.

In the legal sector, firms most commonly report a result for people costs as a percentage of fees of between 55% and 65% and many well-run law firms report results of between 59% to 62%.

People costs in excess of these ranges can indicate inefficiencies, poor pricing or scoping, excess capacity or imbalance in staffing mix . As productivity reduces and people costs increase, it becomes more challenging for a firm to remain profitable.

It is beneficial to also analyse gross margins and people costs at departmental level to identify underperforming or unprofitable practice areas.

Fees generated per fee earner is one of the most reliable KPIs for comparing productivity between law firms because it focuses on the productivity on average of all fee earners in the firm irrespective of whether they are employed fee earners or self-employed owners. A firm should monitor the movement in this KPI over time, as a decrease indicates a reduction in productivity which is very likely to have an impact on profitability. Firms should also benchmark this KPI against similar-size firms. It is common to see a result here between £130,000 and £160,000, however, top 100 firms would often report results in excess of £200,000.

There are several key overheads that represent a significant proportion of a law firm’s expenditure and should therefore be monitored and benchmarked. Spotting overheads creeping up faster than fee income, or generally inefficient cost structures, again helps signal an erosion of profitability early. The key expenses and typical sector results of overheads as a percentage of fees include:

• Computer and IT expenses – between 3% and 8% (however, this could be higher for a firm specifically investing in IT, including AI)
• Marketing and business development – between 2% and 5%
• Property expenses – between 6% and 9%
• Professional indemnity insurance – between 2.5% and 4.5%

Law firms do not necessarily fail due to a lack of profit; they often fail because they run out of cash, so cashflow KPIs are essential for monitoring financial stability.

Lock-up represents the time between starting work and converting it into cash, and it is broken down into WIP days and debtor days.

Many law firms commonly report a lock-up level in the region of 140 days to 160 days; however, firms with high levels of CFA work tend to report higher lock-up levels. High lock-up increases reliance on borrowing/overdrafts or partner capital and weakens financial resilience. A sudden rise in lock-up can be one of the earliest signs of operational strain within a firm.

Ageing WIP and debtors indicates poor matter management or credit control which exposes a firm to a higher risk of irrecoverable WIP, bad debts and negligence risks.

Debt levels are to be considered alongside lock-up. The massive debt levels and unsustainable borrowing were significant contributors to the collapse of SSB Law. Banks will typically lend £1 for every £1 of owner capital in the business. Therefore, levels of borrowing in excess of this, instances of defaulting on repayments or relying on borrowing to service existing debt are all significant indicators of financial instability. Also, where there are growing loan balances, these need to be understood – if loan balances are growing but there is no corresponding investment in growth, why is this borrowing being taken?

There are several other non-financial indicators that should also be considered, such as failure to promptly return client funds, which could indicate cashflow issues within the firm. Also increased complaints, negligence claims or compliance backlogs could be a sign of operational stress in the firm or firm-wide performance issues which should be taken seriously.

SSB Law went through a period of rapid expansion but had not put financial or operational controls in place, which again contributed to its collapse. It is important to ensure that, if a firm does have a strategy of rapid expansion, it has a structure in place that will ensure it has the required level of financial resilience.

A key role of the accountant supporting a law firm is the interpretation of KPI and benchmarking data to provide the owners with real-time performance insight, identify trends and early warning signs and to support meaningful decision making.

This should be provided and reviewed regularly, together with management accounts and annual financial information to ensure a high level of oversight of financial stability of the law firm.