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"We never used to have an overdraft, but..."

13.04.2010

One of the most common complaints we hear from managing partners is "we never used to have an overdraft, but . . ."

In recent years, reliance on overdraft funding has become so widespread that many firms now operate on near-permanent facilities, prompting the accusation from some quarters that banks are seen as providers of ‘quasi-equity’. This dependence on bank funding is one of the (numerous) problems that has emerged from the industry’s single-minded focus on Profit per Equity Partner.

Profit is an Opinion . . .

Focusing purely on PEP has led to the booking of ever-increasing amounts of Work in Progress – which would be fine, if all WIP was billed. However, as WIP contributes to profits before the work is billed, there has been no disincentive to prevent firms from increasing WIP (often only to write it down at a later date). By this time, however, the profits have been posted – and, in many cases, distributed to the partners. Furthermore, the generation of WIP creates a tax liability to be paid. In this way, partners have been drawing on unrealised profits, and the only way to fund this and meet tax obligations has been through increased borrowings.

But Cash is a Reality

The flip side of this coin is that equity partners come to expect a certain level of drawings – especially when the firm is achieving stellar levels of profits ‘per equity partner’. The cycle is thus self-perpetuating, and this has an undermining effect on the firm’s cash flow and balance sheet (an issue to which we will return).

Our repeated mantra is that ‘What Gets Measured Gets Better.’ Until firms get off the treadmill of ever-increasing targets for PEP and learn to focus on measuring cash generation, financial management in law firms will be a continuing uphill struggle – and lenders will not become more sympathetic.

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