Financial stability for law firms: What are the warning signs?

In the first of a series of articles examining the issue of financial stability for law firms, Karen Hain, head of the professional practices team at Moore and Smalley and MHA, explains how to identify if your firm is on the road to financial ruin.

 

A constantly evolving legal services sector, combined with tough economic conditions paints an unsettling picture for many practices.

 

The gravity of the situation is underscored by the SRA’s confirmation that it has placed 160 firms under intensive supervision, following concerns about their financial positions.

 

Against this backdrop of uncertainty, it has never been more important to be aware of financial danger signs, while recognising the importance of sound financial governance, strong cash management and effective business strategy.

 

Many law firms run their finances effectively, but the SRA believes some are still too focused on work volume rather than profitability.

 

The good, the bad, and the best way forward

 

The number of different business models means the way firms handle their finances will vary enormously. However, the basics of solid financial management remain the same and the SRA’s Risk Index sets out lists of good behaviours to aim for and poor ones to avoid.

 

Poor behaviours

 

– Amounts of drawings exceeding net profit levels

 

– High borrowing to net asset ratios

 

– Increasing indebtedness by maintaining drawings levels

 

– Firms controlled by an ‘inner circle’ of senior management

 

– Key financial information not shared with ‘rank and file’ partners

 

– Payments made to partners irrespective of cash in the bank and all net profits drawn, with no ‘reserve capital pot’

 

– Short-term borrowings to fund partners’ tax bills and VAT receipts used as ‘cash received’, resulting in further borrowings to fund VAT due to HMRC.

 

Good behaviours

 

– All partners regularly receive full financial information including office account bank balances

 

– Drawings are linked to cash collection targets and do not exceed net profits

 

– Provision is made to fund partners’ tax from income received

 

– A capital element is retained from profit, and a capital reserve account built up

 

– Premises costs are contained

 

– Profitability levels are tested and unprofitable work is dropped.

 

How Lexcel drives better financial management

 

If your practice is struggling with financial management, you may want to consider the Lexcel accreditation – the Law Society’s practice management standard – which can strengthen your firm’s finances in a number of ways.

 

The process of gaining the accreditation in itself means firms become more profit conscious, proactive, and risk aware. Lexcel provides professionals in law firms with a management framework that drives operational efficiencies, effective risk management, and cost reductions, all of which should result in greater profitability.

 

Additional benefits include better customer service, which means higher client retention rates, increased success in tenders, improved marketability, and more effective risk management which leads to fewer claims and lower insurance premiums.

 

If you would like to discuss a legal practice financial management issue, please call Karen Hain on 01772 821021 or e-mail Karen.Hain@mooreandsmalley.co.uk