Have you the capital?

Late last year, the Law Society of Scotland commissioned a project to provide greater guidance to firms on financial stability, the first part of which goes live this month. It can be accessed from the Society’s website at www.lawscot.org.uk/business-sustainability

Alistair Morris, the Society’s Vice President, had been involved in guidance on this issue some years ago, and strongly felt it was time for more guidance to support firms.

He said: “While there are some encouraging signs of economic recovery, such as increasing house prices, conditions have been very difficult, with most firms having had a tough time since the start of the recession. It’s anticipated that the next few years will continue to be challenging, but, as we start to emerge from the downturn, it’s important that we can provide the right support for our members at this critical time.

“This simple and accessible guidance provides our members with key factors to look at to help ensure effective management of their firm and maintain financial stability, which will allow them to make the most of new business opportunities.”

Profitability has reduced since 2008, and most firms have depleted reserves. The real issue is not profit, however, but cash, and this is made more acute by a greater realisation on the part of most banks that solicitors are not necessarily the “safe bet” they were once presumed to be. They are often not as willing to lend as freely as they once did.

Whys and wherefores

There are many reasons why firms need to improve their financial stability and make their businesses more sustainable. It is in the interests of:

• the partners who own the firms, who not only depend on the practice for an income, but who are likely to be personally liable if things go wrong;

• their staff, whose livelihoods depend on the firm’s survival and success;

• their clients, who shouldn’t have to suffer in terms of service or financially as a result of avoidable firm failures;

• the profession as a whole, as firm failures damage the solicitor brand and reputation of us all.

These guidance notes are intended to be a valuable and confidential method of allowing firms to assess and improve their own financial standing. The contribution of banks and financial advisers to the profession means that firms can have confidence these are the key criteria seen as essential to consider. The materials include:

• a diagnostic to assess how important and how urgent it may be for your firm to examine these issues;

• guidance on areas such as partner drawings and capital;

• key financial ratios;

• a downloadable Excel spreadsheet for firms to use to enter their own data – and a worked example to assist;

• later in the year, free online learning will be launched.

This article looks at two of the key ratios – borrowings v partner capital, and borrowings v unfunded capital, using the illustrations below. For the full guidance, including the other ratios, go to www.lawscot.org.uk/business-sustainability

Ratio 1: Borrowings v partner capital

This key ratio compares the capital the partners have invested in the firm with bank borrowings. The partners should have at least as much invested as the bank, and ideally significantly more.

How do you calculate this?

You will need your year end accounts produced by your accountants. These will show bank borrowing and also the partner capital invested in the firm – it may be split into current accounts and capital accounts, and you should take the total.

Table 1 illustrates an example firm with two partners:

This firm has relatively little partner capital compared to the amount invested by the bank – over time they would need either to increase the amount of partner capital in the firm, reduce their borrowings, or probably a combination of the two.

Note: The indications in this section of what a bank might look for are based on one bank’s opinion – other banks might take a different view.

Action needed?

If you have less capital invested than the bank, it is a cause for concern. You should always have more capital invested, so that in the event of a change in bank lending policy, you are not exposed. It will take time to change this – perhaps three years – and will be achieved by a combination of capital injection, reduced drawings, and better billing and cash collection.

Ratio 2: Borrowings v unfunded capital

The first ratio looked at borrowings shown on the balance sheet. However, many firms, and in particular most larger firms, have “off-balance sheet” borrowings in the form of professional practice finance loans and, in some cases, these are substantial. Most partners appointed in the last 10 years are likely to have one.

Taking the example firm, whereas partner 1 has been with the firm for many years and has over time built up his capital, the new partner was given a professional practice finance loan to fund her capital of £50,000. This is secured on the assets of the partnership and is interest only, with the capital being repayable when she leaves the firm.

How do you calculate this?

The calculation is the same as shown in table 1, except you also need to take into account any professional practice finance loans the partners have. These obviously are not included in the firm’s balance sheet – you will have to ask each partner what the balance is. Your bank will be very interested in the firm’s unfunded or “free” capital relative to borrowings, as illustrated in table 2.

The unfunded capital ratio will be difficult for most firms to change, at least in the short term, due to the scale of change needed, and the fact that these are long-term loans. However, your bank will be aware of it and it will influence their view of you.

Action needed?

Most new partners have been given these loans in recent years on an interest-only basis. These will often be younger partners in their 20s or 30s who will be unlikely to be able easily to replace them with their own capital. The problem with such loans is that they assume there will be an easy way of repaying them on retirement, and that may not necessarily be the case. There could be much sense in partners repaying elements of the capital over time, or at the very least making provision for its repayment, and this may well require an adjustment in profit shares. It is possible that the banks will move towards making loans for future partners on a repayment basis, so avoiding potential problems when a partner leaves or retires.