Is Your Firm Designed to Be Cash Positive?
In recent months I have spent time writing the update to my book Cash Flow Management for Law Firms and have now been asked to prepare a Masterclass, deliver public lectures and provide training courses on this subject.
As any of you who deliver seminars will know, you have to be better prepared than your students, have answers ready for any questions you can anticipate, and at times have to do go well below the surface in understanding the subject.
Late last year I delivered a Finance Masterclass to a group of 18 managing partners. Fifteen of the eighteen said that Cash Flow Management was their biggest single issue, and it did not matter whether the firm was growing or struggling. As one managing partner said “We’re happy with the profit that our firm is making, we just want to be able to draw it. It seems that no matter how much we grow the firm, all the extra profit needs to be retained.”
The more deeply I investigate the cash profiles of a variety of law firms, the more I am convinced that there is a fundamental design flaw in the way many firms are set up to operate.
Many years ago I worked as a Financial Analyst in the motor industry, specialising in Cost Management and Control. Coming from an accounting background it came as a revelation to learn that 80% of the cost of production is predetermined before a single car has been made. This largest element is determined by the designers – both the designers of the actual vehicle and the designers of the production process. Unfortunately for many western firms, the Japanese recognised this first and led a revolution in manufacturing.
After 20 years working with law firms of all sizes, I have become convinced that the same principle applies. The cash flow profile of law firms is largely determined by the “design” of the firm. As with the manufacturers, this applies at two levels. The first level, and by far the most important, includes the main structural set up, culture and key policy decisions around clients and market selection. The second level includes the main operating systems and processes that the firm will use.
These set the limitations on the cash generation capability of the firm, irrespective of how well the partners and staff actually implement policies. This is not to say that operational competence is irrelevant – far from it – but in many firms it is less significant than the design and policy decisions taken by the partners.
In some cases (Personal Injury and Clinical Negligence are amongst the most obvious), the faster the growth, the more cash-hungry the firm becomes. Of course, profitable growth is a good thing –provided that investors are prepared to finance it, which becomes a question of risk and reward.
Vehicles for Extraction
But it is here that we hit perhaps the biggest obstacle. Partnerships, and especially law firms, are vehicles designed for extraction not growth. The essence of the culture of most law firms is “how much can I draw and how soon?” The main published law firm metric used to compare performance and motivate partners is Profit per Equity Partner, which is a backward-looking measure of extraction capability. The more the firm makes, the more the partners can extract. By contrast, the main published metric of public companies is the share price, which is a forward-looking measure based on earnings (historic and prospective), and a multiple – which is based largely on future (growth) prospects.
In future articles and in the public presentations I shall be looking more closely at some of the key design decisions partners need to understand, including factors influencing income profile, such as Client and Market Sector Selection, Work Type Selection, Pricing Parameters, Terms of Trade, and the implications of Risk Reversal (excellent for profitability, not so for cash flow). We will also look at a range of factors which determine the profile of cash outflows.