Financial Stability by Sponsor PKF Francis Clark

Two words that many of us will remember as the buzzwords from the SRA in 2007 to 2009; the time at which the last recession started to bite in many law firms. Whilst it is true to say that the financial performance of the legal sector today remains buoyant compared with that period we have seen some early signs of instability creeping back into the sector with some more potential challenges on the horizon.

 

In this article we briefly consider some of the sources of this instability and direct firms to some early actions they might consider taking to reduce the scope for problems developing.

 

1) Increased partner retirement rates

 

Challenge: Demographics and to some extent less appetite from individuals to join law firms as equity partners is slowly producing a net outflow of cash. The momentum for this is growing because many partners delayed their retirements after the 2008 recession so there has been more “bunching” of retirements in many firms.

 

Possible actions:

  • Earlier planning of partner retirement and appointments
  • Capital funding model to give advance notice to partners of increased capital requirements
  • Communication with external funders of overall business funding model
  • Maintaining reliable management information to provide confidence to funding providers and partners of underlying profitability and sustainability.

 2) Higher volumes of CFA based work

 

Challenge: A wider range of work now operates with some degree of conditional fee compared with 2008. This is a trend which is likely to gain further momentum. This has a negative impact on cash flow in the business even if sometimes it can be positive from a profit margin viewpoint.

 

Possible actions:

  • Controlling the mix of CFA work types with other cash generative work types in the firm
  • Strong financial information to assess success rates and profitability of CFA matters
  • Consideration of trading structure to finance lock up
  • Early review of long term mix of balance sheet debt and equity.

3) Lower profit margins

 

Challenge:  Regulatory changes and increased competition in the sector have all contributed to declining margins in a range of mainstream work areas for law firms. Over time this has been reducing both gross and net profit levels in firms.

 

Possible actions:

  • Drawings need to be linked to profitability on a regular basis
  • Work allocation – ensure appropriately skilled (and cost) staff undertake appropriate elements of work on individual client matters; move away from partner / fee earner “ownership” of a matter
  • Productivity focus – chargeable hours and recovery rate focus at a fee earner level
  • Process review – consider the various types of work and consider where value and costs are added.

4) Investment in law firm businesses

 

Challenge:  The issue here is the need for law firms to invest to meet the changing market place and increased competition. The big cash investment areas are generally in I.T and marketing in most firms. The cost of these investments can increase debt in the balance sheet and repress reported profits even though the cash demand from partners at a drawing level continues.

 

Possible actions:

  • Ensure there is appropriate future reward for partners giving up profits today for investment in the future
  • Make sure appropriate debt is matched with appropriate spend – e.g. don’t use an overdraft for fixed assets; use a medium term loan with amortisation periods in line with depreciation, write down levels in the financial accounts.
  • Where significant profit retention is required to support investment consider whether a limited company within the trading structure might be part of the solution.

5) Better informed lenders

 

Challenge: Lenders continue to have an appetite for the legal sector but in our experience over a period of time it is more volatile than 10 years ago. They are quicker to make decisions and form policy views and they understand the information they need from law firms much better. For law firms this presents a more volatile position but one which can be managed.

 

Possible actions:

  • Reliable, relevant and regular management information for third party lenders (monthly)
  • Full financial forecasts; monitored against actual on a monthly basis
  • A clear plan on business debt versus partner equity levels
  • Sensitivity analysis of business plans and projections
  • Demonstration of partner / owner commitment to the business.

 

The sector is facing some different challenges in 2019 such as the SRA regulatory reforms, which have now been approved by the LSB opening the legal market to non-regulated practices to provide non reserved legal services. This will potentially be combined with Brexit and the uncertainty within the economy that comes with this.

 

Early action by firms to address the challenges on the horizon will place them in a stronger position for the future.

 

Our legal sector team at PKF Francis Clark works closely with a range of law firms to help them with areas such as financial management, profit improvement and strategic planning. If you would like to discuss the future of your firm with us please get in touch.

 

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This publication is produced by Francis Clark LLP for information only and is not intended to constitute professional advice. Specific professional advice should be obtained before acting on any of the information contained herein. Whilst Francis Clark LLP is confident of the accuracy of the information in this publication (as at the date of its issue), no duty of care is assumed to any direct or indirect recipient of this publication and no liability is accepted for any omission or inaccuracy.

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