One of the difficulties in assessing the state of the legal market has been the paucity of up-to-date data. In the UK we have largely had to rely on historic annual data (various league tables published about large firms, the law management section survey of medium sized firms, and those created for various consortia) which, by the time it is collected and published, can be of limited use.
They do things differently across the pond, where quarterly reporting is an act of faith, and Citigroup have for some years published a quarterly survey of law firm profitability which covers most of the top 200 firms in the USA. The consistency of the survey and its regularity has enabled us both to form a picture of the historic trends, and to be able to use some of the data to predict the short/medium term future. For over a year now several of the trends have given cause for concern:
• Revenue collection has been growing on average (but see my separate article about the danger of averages) but operating costs – and particularly staff costs – have been growing faster
• The amount of billable hours appears to be declining quarter by quarter
• Firms are reporting a steadily increasing need to discount their fees
• These seemingly contradictory impacts can partly be rationalised by the fact that firms are turning hours into bills and bills into cash more quickly – American firms operate on the cash accounting basis
• Staff costs in the most recent quarter were only contained by many of the largest firms failing to pay spring bonuses.
A Step Forward in Law Management
Most accountants would suggest that an industry in which headcount and operating costs are growing whilst productivity and revenue are declining is only headed in one direction, and it may not be pretty to watch. But at least we will be able to say that we were not surprised when the inevitable happens.
Until recently we have not had a similar survey in the UK – but step forward the Law Management Section, who have now introduced a quarterly benchmarking report which, like their annual benchmarking survey, covers primarily medium sized firms. (I can claim no credit for this since it was initiated before my election to the LMS, but I commend my colleagues for this initiative). I understand it will be available shortly to all LMS members free of charge.
Squeeze on Cash Flow
The headline extracts from the reports have highlighted in particular the squeeze on cash flow, with over 40% of firms reporting more cash flow pressures than in the previous quarter. In particular, the fact that many firms are operating so close to their overdraft limits is worrying, as being cash constrained can severely limit a firm’s freedom of action. Some years ago I was told by a happy client that the main benefit from our solving his cash flow problems was not about the money, but the fact that he could sleep at night and spend his time in the office managing the firm and earning fees rather than worrying about where the next cheque was coming from. I've recently taken to asking partners about their sleeping habits (!) and from my informal surveys a lot of sleep is being lost and a lot of office time wasted due to the stress resulting from poor cash flow.
And yet, the survey shows that the median fee income is up on last year – so why are firms suffering a cash squeeze? There are probably two explanations and this relates to my previous article about the dangers of averages. As with the larger firms, many medium-sized firms are approaching the fork in the road which separates those following virtuous and vicious cycles.
Those firms suffering a shortfall in revenue will also be suffering cash shortages due to their inability to flex their costs in line with revenue. The answers here will require an element of surgery.
Those firms that have increased their revenue may in effect be overtrading. In the same way that insolvencies peak at the start of the upturn, as firms find they have inadequate capital to rebuild, growing a firm with a long lock-up cycle without increasing the capital base is bound to test the borrowing capacity to the full. In this case, the answers are far less painful and require a resetting of the lock-up cycle on a far more realistic commercial basis. In many areas of work and in many firms a relatively straightforward process can take 2 to 4 weeks out of the lock-up cycle and remove all pressure on borrowings. However, it does require fee earners to take responsibility for financial management of their files as part of their professional standards.
As a financial analyst I find that the new LMS quarterly survey has posed as many questions as it has answered – but once it settles down and the trends become more clearly understood it will be truly invaluable – even more so if more firms take part (and you do not have to be an LMS member to do so).
Please email firstname.lastname@example.org if you would like to discuss any of the issues raised in this article.