Perhaps the timing was coincidental but the January seminar of APP, the Association of partnership practitioners, was particularly interesting.
The seminar was entitled "managing a professional services firm in distress" and the main speaker was Dermot Power – best-known as the administrator of Halliwells, the Manchester firm which went under not long after declaring a turnover of £80 million and a profit per equity partner of over £500,000.
Dermot started by saying that the recently published official data suggesting we are in recession only serve to confirm the anecdotal evidence many of us have seen – but then made the key point that in a recession demand for most legal services will fall. Not a good start to the year.
He also indicated that (prior to the new recession) his firm had recently conducted independent business reviews for law firms turning over £30 million, £60 million, and £90 million. So not all of the problems are at the smaller firm end of the market!
One of his key insights was that over the last 20 years Work in Progress has played a major role in changing the funding structure of law firms. Until the 1990s, WIP was not formally recognised in the accounts, and nor was it taken into consideration in lending formulas. Up to 2008 WIP was identified by accountants as a tangible asset, recognised by HMRC and is taxed accordingly and used in lending formulas (by both firms and bankers) to justify increased borrowings.
One of the consequences of the banking crisis and recession that resulted was that it exposed the questionable quality and recoverability of much WIP. It also exposed how little the lenders truly understood the asset against which they were lending. Naturally, this means that lenders are far less keen to lend against WIP.
The conventional view is that firms need to do two things – firstly, to be far more circumspect in their accounting for and valuation of WIP internally; and secondly, if they want the banks to lend, they have to be far more clear in their communication with the bank of how and why the WIP justifies its valuation.
Regular readers will know that we very strongly believe in a third imperative, which is to pay far less attention to the accountancy and far more to the cash flow and the realisation of the WIP. Put simply – turn it into cash as quickly as possible.
A Cultural Shift
As the research for our 2010 report Cash Management for Law Firms identified, to do this successfully requires not just a big stick approach, nor even just systems – but a cultural shift. Fee earners need to be educated in the cash flow imperative and have appropriate cash flow standards (rather than targets), not only established for each work type but rigorously adhered to.
But if we are heading into a recession then firms need to be extra vigilant in adhering to standards. If work is scarce there is a temptation to take on work on unclear or less stringent terms – which will only lead to increases in WIP and worsen cash flow just at the time you need positive cash flow. Fee earners need to appreciate that WIP is essentially a wasting asset and performance measures need to be far more clearly focused on bills collected, rather than bills raised or even worse chargeable hours created.
It 2012 is going to be a difficult year, financial disciplines will be crucial not only in work in progress management, but also in cost management as we see in our blog on Cost Reduction in the New Legal Market.