Financial Statement Analysis for Law Firms (Prepared for the British Columbia Legal Management Association) April 2014

John Moore, CPA, CA Debbie Dane, CPA, CGA

Financial Statement Analysis for Law Firms April 2014 Page 2

All law firms, from sole practitioners to huge nationals, need financial statements. Annual financial statements are used for income tax purposes, and provide a snapshot of financial results at a specific point in time. However, they don’t indicate how or why the results were achieved, or offer any real insights into how to improve. Components of the financial statements can be used to calculate ratios, which are a useful indicator of a firm’s performance and financial situation. Financial ratios can be used to chart a business’s progress, uncover trends, and point to potential areas of concern. On their own, financial ratios may not provide much additional information. But when compared to prior periods or other firms, financial ratios are a powerful tool. The four major ratio types are classified as: 1. Liquidity Ratios – measure the firm’s solvency and ability to pay current bills and short-term debts. 2. Activity (Turnover) Ratios – measure the efficiency of the firm in converting its assets into revenue and cash. 3. Leverage (Debt) Ratios – provide an indication of the long-term solvency of the firm by measuring the extent to which the firm is using long-term debt. 4. Profitability Ratios – measure success of the firm at generating profits. Ratios can also be classified by the financial components used in calculating them: 1. Balance Sheet Ratios 2. Income Statement Ratios 3. Composite Ratios (balance sheet and income statement items)

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Liquidity Ratios Liquidity is an indicator of the firm’s ability to pay its short-term obligations.

Current Ratio (Working Capital Ratio)

Current Assets Current Liabilities The current ratio measures the ability of the firm to generate cash to meet its immediate debts. Short-term creditors prefer a high current ratio as it reduces their risk in extending credit. Owners may prefer a lower ratio so that more of the firm’s assets are being used to further the business (or are being distributed to the owners). Quick Ratio (Acid Test Ratio) Cash + Accounts Receivable + Short-term Investments Current Liabilities Or Current Assets – Prepaids - WIP Current Liabilities Some current assets are not immediately convertible to cash. For example, work in progress (WIP) still has to be billed and collected. The quick ratio is an alternative to the current ratio using only those current assets that can quickly be converted to cash for payment of debt.

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Net Working Capital Ratio Current Assets – Current Liabilities Total Assets A high net working capital ratio is an indicator that firm assets are not being utilized in an efficient manner.

Activity (Turnover) Ratios Turnover ratios are a measure of how efficiently the firm manages its assets.

Receivables Turnover Accounts Receivable Annual Revenue / 365 Measures how quickly the firm collects its accounts receivable, providing insight into the effectives of extending credit and collecting accounts. The ratio can also be calculated on a monthly basis: Accounts Receivable at End of Month Revenue for the Month / 30 When compared on a monthly basis, can be an indicator of potential cash flow problems. An increase in the ratio each month indicates receivables are growing faster than billings. Receivables over 180 days Accounts Receivable > 180 days Total Accounts Receivable

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Although not a turnover ratio, the composition of accounts receivable provides additional insight into turnover. A higher ratio indicates potential collection problems that should be investigated further (client solvency problems, inadequate follow up, etc.) Work in Progress (WIP) Turnover WIP Annual Revenue / 365 Measures the amount of time to convert WIP into actual revenue. As with accounts receivable turnover, can also be calculated on a monthly or quarterly basis. Work in Progress over 180 days WIP > 180 days Total WIP Again, as with accounts receivable, the composition of WIP is very important. The longer that WIP is unbilled, the harder it becomes to bill and collect.

Financial Leverage (Debt) Ratios Leverage ratios measure the long-term solvency of the firm and the extent to which the firm is using external debt to finance its operations. Creditors look at debt ratios when deciding to loan funds. Many creditors also ensure that debt ratios are maintained at a certain level throughout the lending term. Debt Ratio Total Liabilities Total Assets Measures the degree to which the firm’s assets are financed with external debt. A high ration may indicate that the firm is over leveraged and many have issues meeting future debt payments.

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Debt to Equity Ratio Total Liabilities Equity Measures the firm’s reliance on external financing and the firm’s indebtedness compared to the amount invested by the owners. It is a measure of risk for creditors. The higher the ratio, the greater the external financing and the higher the risk to lenders. Debt Service Coverage Net income plus amortization plus interest plus non-cash expenses Principal + Interest Measures the debt servicing ability of the firm. A ratio higher than 1 indicates that the firm is able to generate enough income to satisfy its debt payment requirements. A ratio less than 1 means negative cash flow. Debt per Equity Partner Total Debt # of Equity Partners Always of interest to the partners as it indicates their approximate share of the firm’s debt. Profitability Ratios Provide measures of the firm’s success at generating profits. Firm Revenue per Partner Revenue # of Partners

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When compared to prior periods, is a measure of revenue growth. Can also be calculated as revenue per lawyer. Net Earnings per Partner (Profits per Partner) Net Income # of Partners Over time, is a measure of profitability growth. Can also be calculated on a per lawyer basis. Doesn’t necessarily align with revenue, as is dependent on both revenue and expenses. Return on Equity (Return on Investment) Net Income Equity Measures the profitability of the firm in relation to the owners’ investment left in the firm. Expenses Expense categories should be reviewed on a periodic basis to determine if costs are properly controlled. Calculating the ratio of each expense to revenue determines the relative significance of an expenditure category. Comparing the ratios to prior periods will give an indicator of expense change in relation to revenue. Calculating the ratio of each expense category per partner and per lawyer allows comparison with other firms. Many expenditure categories are fairly small and the added administration to manage these costs may outweigh any real benefit. Major expenditures to monitor include wages and benefits, non-partner lawyer costs, occupancy costs, technology costs, and advertising and business development costs.

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PROFITABILITY DRIVERS The bottom line is usually the most important number to law firms and lawyers, measured by:  

Overall net income or profit, and Net income or profit per partner or per lawyer.

With the emphasis on profitability, the reflex reaction to lower profits is cost cutting. Cost control is important, but law firms do not grow by focusing on costs alone. Long-term growth is achieved through revenue growth. Cost cutting and cost control have diminishing returns. Many cost categories are not able to be reduced without a substantial impact on practice efficiency. Revenue growth is potentially unlimited. As long as the revenue growth exceeds the expenditure growth, profitability will improve. Noted law firm consultant David Maister quantified the factors of law firm profitability as follows: Profits per Partner = Utilization x Billing Rate x Realization x Leverage x Margin Costs , which are included in the margin (net income / realized fees), are only one of five components in profitability. Changing any one of the components has an impact on profitability, and profits per partner. Time Much has been written about moving away from the concept of the billable hour and the adoption of value pricing. That being said, the majority of law firms still use hours to determine billings and to track employee productivity. Hours are still a key profitability driver. As hours are a key component of profitability, it is very important that they be tracked and measured effectively. Time should be tracked and recorded on a daily basis. By recording hours as soon as possible, nothing is forgotten or missed. Daily recording increases accuracy and increases the amount of billable time.

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Utilization Total Billable Hours Total Billable Personnel Utilization is a component of productivity. With a focus on chargeable time, it is important to ensure that chargeable time is being generated by billable personnel. It is a good idea to monitor the chargeability of staff as follows: Billable Hours Total Hours Can be tracked on a monthly basis and can be used to compare annual and seasonal trends, and compare to other firms. Average Billing Rate Billings Billable Hours Should be reviewed by practice area – a high ratio can be an indicator of growth potential in practice areas. Time Value Added Billable Hours X Standard Billing Rate (Chargeout Rate) Basically, this is the time that goes into Work in Progress (WIP). Can be used to determine productivity of staff, but must also take into consideration realization.

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Can be used to monitor staff productivity: Time Value Added Salary Billings A firm can track billable time, time value added, etc., all it wants, but there is very little value to the firm if it is not invoicing clients. Billings should be reviewed regularly and compared to prior periods and budgets: 

Total firm billings



Billing of top 10 or 50 clients (diversification)



By practice area



By attorney

It is very important to bill promptly – the value of the service to the client declines in proportion to the time between the performance of the service and when the service is ultimately invoiced. Take into consideration the 80 / 20 rule - can bring in 80% of your revenue with only 20% of your effort. Realization Billings Time Value Added Although chargeable time is included in WIP, this does not mean that the WIP is good and can be fully billed. Realization measures the portion of accumulated chargeable time that has actually been billed.

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Lower realization rates can be an indicator of:   

Not billing on a timely basis Not billing enough / pricing problems Efficiency problems

Collections It’s not enough to simply invoice for work. The invoices still have to be collected. Poor collections could have simple explanation such as invoices not being delivered in timely fashion or not being followed up. However, can also be an indicator of more serious problems such as unsatisfied clients or financially unstable clients and practice areas. An alternative realization calculation is based on fees collected rather than fees billed. In the end, if the fees are not collected, they are not contributing to the firm’s profitability. Billings – Bad Debts Time Value Added

Leverage Total Billable Personnel Total Partners Leverage is a measure of the firm’s ability to deliver services with a higher proportion of lower cost personnel. Profitability can be increased by shifting work to lowest cost effective labour source.

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Profits per Partner (Average Partner Income) Net Income # of Partners As discussed at the start of this section, profits per partner can also be calculated as: Profits per Partner = Utilization x Billing Rate x Realization x Leverage x Margin A change in any of the components can have an impact.

Profit per Partner = Utilization x Billing Rate x Realization x Margin x Leverage

A B C D E F G

Leverage Utilization Billing Rate Realization Margin

Partners Billable Personnel Billable Hours Time Value Added Realized Fees Expenses Net Income

B/A C/B D/C E/D G/E

Profit per Partner

(1) (2) (3) (4)

Billable Personnel / Partners Billable Hours / Billable Staff Time Value Added / Billable Time Realized Fees / Time Value Added Net Income / Realized Fees

Starting Point

Increase Leverage (1)

Increase Increase Utilization Realization (2) (3)

Increase Margin (4)

5 20 30,000 3,000,000 2,700,000 1,500,000 1,200,000

5 24 36,000 3,600,000 3,240,000 1,800,000 1,440,000

5 24 37,000 3,700,000 3,330,000 1,800,000 1,530,000

5 24 37,000 3,700,000 3,515,000 1,800,000 1,715,000

5 24 37,000 3,700,000 3,515,000 1,750,000 1,765,000

4 1,500 100 90% 44%

5 1,500 100 90% 44%

5 1,542 100 90% 46%

5 1,542 100 95% 49%

5 1,542 100 95% 50%

240,000

288,000

306,000

343,000

353,000

Increase leverage by adding 4 new staff at a cost of $300,000, resulting in 6,000 additional chargeablle hours Increase utilization by obtaining an additional 1,000 chargeable hours Increase realization from 90% to 95% Increase margin by reducing expenses by $50,000

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In the end, financial statement and performance metrics are just numbers. Sound judgement and understanding make them important tools.

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About the Authors John Moore, CPA, CA Associate, Professional Services at Wolrige Mahon LLP Practice concentrated on accounting, tax and financial planning for legal, health and other business professionals. Email:

[email protected]

Blogs:

The Professional Edge The Legal Accountant

http://professional-edge.ca http://legalcpa.ca

Debbie Dane, CGA, CA Senior Manager, Audit and Accounting Has been with Wolrige Mahon for over 20 years focusing on the tax and accounting aspects of professional services firms and owner-managed businesses. Email:

[email protected]

About Wolrige Mahon LLP Wolrige Mahon is one of the largest independent accounting firms in Metro Vancouver with more than 90 professional staff who can meet client needs with a full spectrum of business services including audit and accounting, taxation, business valuations, litigation support, corporate finance, information technology, insolvency and restructuring. Web:

http://www.wm.ca

Email:

[email protected]

Tel:

604.684.6212