Cash flow: the five essentials

The 2008 Cost of Time Survey once again saw a good response, with 219 firms participating – just under 20% of all firms in Scotland. They comprised nearly 2,000 fee-earners and had a combined fee income of £262m. Once again the survey provides some very useful benchmarks on working capital and cash, and in the current climate effective cash management is key.

As we move from winter to spring the outlook remains tough for most firms both north and south of the border. Anecdotally, two firms in England commented to me recently that January had been better than expected, and at a recent networking event in Glasgow run by my colleague Fiona Westwood, one or two firms similarly reported a short lived uplift in early February. The position for most firms however remains difficult.

Some areas of work of course are busy. Many family practitioners have been busy since the new year – however as they are often paid from the sale proceeds of the matrimonial home, they may not actually see much cash for a while. Personal injury and executries are both doing well and will be an important source of cash flow, and the changes to legal aid eligibility may well mean increased volumes for legal aid firms, albeit at unchanged rates. Property, the mainstay for many firms, however remains virtually non-existent with volumes way down from last year. Land Register statistics indicate a 53% fall from 2007 levels, but anecdotal evidence suggests even greater falls at the present time. A manic January in 2008 has been replaced by a very quiet January in 2009.

Central figures

There will come a point where the market starts to recover; however for now the focus must be on survival and in particular on cash. For many firms, billing, debt collection and working capital management are all areas of weakness, and many firms still do not time record. You can get away with this when times are good, but not when times are difficult. The priority for all firms over the next six months must be cash collection and the role of the cashroom partner is going to be even more important. In particular:

(1) Ensure your cashroom produces reports of debtors, work in progress and bills promptly at the end of each month, certainly within the first two or three days. They will typically produce long reports each month. Spend some time looking at what is available and distribute the detailed reports as appropriate to fee earners.

(2) Design a one-page summary that reports the main figures from these detailed reports, the totals and key measures. Maybe use charts, and give comparisons over, say, the previous six months.

(3) The five key figures to focus on in this report and get everyone in your firm thinking about are likely to be:

(a) debtor days – which is an effective and simple way of assessing whether the amount tied up in debtors is too high;

(b) amount of debtors over two months old – the areas where you are most at risk of bad debts;

(c) WIP days;

(d) amount of unbilled outlays;

(e) daily cash collections.

Explain the importance of monitoring these areas to (a) your partners, (b) your other fee earners and (c) to your support staff, and decide what information can be circulated to each group. Distribute as much as possible – your staff have as much interest in the firm getting paid as you do. Some firms will distribute the summary to all staff – on the staff notice board and updated monthly. The cumulative cash collection for the month to date would be updated weekly or even daily. There is nothing especially confidential and the key is to get everyone focused – remember, what gets measured gets targeted.

If your firm does not already time record, start doing so – it is your best way of keeping track of what everyone is doing and where their time is going.

A closer look

To look at each of the key figures in more detail:

Debtors

Remember that your credit control system starts with your initial engagement letter. You might be delighted to have the client, but you need to be clear about the money – and your client will respect you more for being so:

Ensure you are clear in your initial engagement letter about likely fees; that you will issue interims; that you will issue your final bill promptly; that you will expect payment within x days.

If it is a commercial client check their credit rating. If it is a longstanding client check it again, as it may have changed from last month.

Send regular interims – monthly if the matter is significant, quarterly for all other matters. Clients prefer to know where they are, it avoids surprises at the end, and of course it helps your cash flow.

Bill promptly at the end of the matter and let the client know it is coming. The fee earner should speak to the client and explain if the bill is different to what has been discussed previously.

Let your cashroom chase for payment. Don’t interfere or hamper them.

Do everything you can to avoid bad debts. Any increase in bad debts will come straight off your bottom line profits.

To take a simple example, let us assume that at the end of January total debtors were £258,750. The amount over two months old should be easy to find from the aged debtors report.

Debtor days

This is an easy figure to calculate, as illustrated in table 1.

The table takes the total debtors at the end of the month, excludes VAT and then deducts each month’s fees until zero is reached. It is of course a simplification to say that all of January’s fees are outstanding, and you must resist the temptation to overcomplicate this calculation; however to focus on a single figure is a very powerful way of focusing minds.

Debtor days were 87, quite high as indicated by the chart seen in table 2, which is taken from the survey.

In the report we calculated this figure by dividing year-end debtors by each firm’s average daily fees. Because most firms that undertake legal aid only post their legal aid bills when they are paid, average daily fees excludes legal aid fees. The figures in this chart for smaller firms should be treated with care, as the low figures might indicate that much of their business is accounted for on a cash basis. You need to ignore work on a cash basis in this calculation.

Across all the size groups some firms have reported very high figures. A quarter of 10+ partner firms have debtor days in excess of 142 days or 4 1/2 months, which is very high, and the median of 91 days is also high. A similar survey published by the Law Management Section, part of the Law Society of England & Wales, reported median debtor days for 11-25 partner firms of 74 days with an upper quartile figure of just 85 days, which suggests that firms in Scotland are not as good as their equivalents south of the border at getting paid. Firms that are currently high should make reducing this figure a priority, otherwise they run the risk of high levels of bad debt.

WIP days

The calculation is very similar to that for debtor days, but compares the total value of work in progress each month with the value of work done each month. Both should be valued at selling price and should include partner time. It is useful for even small firms to time record and to monitor this figure, because you are selling time and expertise and you need to understand how the time you are paying for has been used.

Unbilled outlays

Many firms incur outlays on behalf of clients and do not recover them until the end of the matter. Once again this is acceptable during good times, but not when everyone is under pressure.

Table 3 shows the chart from this year’s survey, indicating that many firms carry high levels of outlays – for a quarter of firms this figure was over £10,000 for each fee earner.

There will be few firms who can easily fund these levels of outlays – it merely adds to the pressure. Once again, the key is the initial engagement letter. Explain what outlays are to be expected and when you will require the funds. Even long established clients should appreciate that in the current climate you cannot be a banker to them. It is not a matter of lack of trust in them it is an issue of managing a scarce resource, and one that is outside your control. Hopefully they will understand.

Daily cash collections

The final figure to focus on in the monthly summary is daily cash collections – the amount you need to collect each day and the actual so far this month, both on a cumulative basis. For example, in March 2009 there are 22 working days. Let us assume that the amount you need to collect in cash over the month to pay salaries, partner drawings, tax, suppliers, standing orders, etc, is £50,000. That equates to £2,300 a day. By Friday 6th we will need to have collected £11,500, by Friday 13th, £23,000 and so on. It would be very easy to have a chart on the wall in the kitchen or staff room that shows our actual collections by the end of each week, the cumulative for the month so far.

At the end of the day this is the key figure – no cash, no salaries; no cash, no drawings. Once again by focusing on a single figure you can achieve much more than reams of reports, and by circulating the figure widely the people who can influence it get involved.

The bottom line at this stage therefore is cash – and the key areas to focus on are:

Debtor days;

Debtors over two months old;

WIP days;

Outlays;

Daily cash collections.

The next article will look at three other important areas – fees, gross margin and overheads.

Andrew Otterburn is running a series of seminars for Update that build on these articles and explain in more detail the actions firms need to be taking at the present time: 30 April, Dundee; 21 May, Glasgow; 4 June, Edinburgh. Further details at www.lawscot.org.uk/update .

Otterburn is a management consultant and for many years has run practice management seminars on behalf of the Society. He has helped in the development of the Cost of Time Survey since 1999. The second edition of his book, Profitability and Law Firm Management, is published by the Law Society in London. He is a founder member of the Law Consultancy Network, a network of independent law firm consultants. The statistics upon which the article was based were supplied by Dr John Pollock, a consulting actuary, who has been responsible for the administration and statistical aspects of the Cost of Time survey since 2002. John is well known to personal injury, employment and family law solicitors in Scotland through his expert witness work at Pollock & Galbraith Consulting Actuaries.