Borrowings, partner capital and profitability

Using illustrative examples, this article explains three key ratios that banks use to assess the profitability of their law firm clients

19th March 2018 | Andrew Otterburn

Some firms are doing well; however most firms in Scotland have seen relatively flat profits over the last four years. Hopefully the market will continue to improve; however there is every chance of a fall in confidence over the next year as markets become spooked during the Brexit negotiations.

As all managing partners will know, we need profitability, but above all we need cash, and during any time of uncertainty it is not good to be overdependent on bank borrowing. All the banks look at particular metrics in assessing their law firm clients, and this article describes three of the more common ones that you may also like to calculate. My article published at Journal, February 2014, 34 described the first two metrics; however this updated article adds a third – the “make and take” ratio.

Ratio 1 – Borrowings: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, 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; you should take the total.

Table 1 illustrates an example firm with two partners:

Table 1: Borrowings: partner capital

Office account		–50,000
Bank loans		–75,000
Total (non-property) borrowings		–125,000
Partner capital
Partner 1	50,000
Partner 2 (newly appointed)	50,000
		100,000
Ratio		125%
What might a bank want?		100% or less

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

This firm has relatively little partner capital, and less than the amount invested by the bank. The bank has more at risk than the partners. Over time the partners would need either to increase the amount of partner capital in the firm, or reduce their borrowings, or probably a combination of the two.

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: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 her capital, the new partner was given a professional practice finance loan by the firm’s bank to fund his capital of £50,000.

How do you calculate this?

The calculation is the same as shown in table 1 except that 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:

Table 2: Borrowings:unfunded capital

Office account		–50,000
Bank loans		–75,000
Total (non-property) borrowings		–125,000
Professional practice finance loan		–50,000
Total borrowings		–175,000
Partner capital
Partner 1	50,000
Partner 2 (newly appointed)	50,000
	100,000
Less professional practice finance loan	50,000
Unfunded capital		50,000
Ratio		350%
What might a bank want?		175% or less

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 easily able 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, but that may not necessarily be the case. There could be much sense in partners repaying the capital over time, or at the very least making provision for its repayment, and this may well require an adjustment in profit shares.

Ratio 3: Profits:drawings – the “make and take” ratio

The two ratios discussed so far concern the levels of borrowing relative to partner capital, and the main way this can be improved is often to leave more profit within the firm by reducing partner drawings. This ratio compares drawings with profits and is illustrated in tables 3 and 4, which relate to the small firm illustrated already and also show a larger firm with £10 million turnover.

How do you calculate this?

Simply take the profits available for the partners as shown in the accounts and compare this to total drawings in the accounts. This will comprise monthly drawings and payments of income tax.

Table 3: "Make and take" ratio, two-partner firm

	Accounts basis	Cash basis
Fees	400,000	400,000
Opening work in progress/accrued income	–100,000	–100,000
Closing work in progress/accrued income	150,000	150,000
Income	450,000	450,000
Staff salaries and overheads	317,500	317,500
Net profit per accounts	132,500	132,500
Adjust for WIP movement (paper profit)		–50,000
Cash profit		82,500
Change in debtors	-	-
Cash available		82,500
Monthly drawings	79,500	79,500
Partner income tax	53,000	53,000
Total drawings	132,500	132,500
"Make and take" ratio	100%	161%

Table 4: "Make and take" ratio, larger firm

	Accounts basis	Cash basis
Fees	10,500,000	10,500,000
Opening work in progress/accrued income	–2,000,000	–2,000,000
Closing work in progress/accrued income	2,500,000	2,500,000
Income	11,000,000	11,000,000
Staff salaries and overheads	8,000,000	8,000,000
Net profit per accounts	3,000,000	3,000,000
Adjust for WIP movement (paper profit)		–500,000
Cash profit		2,500,000
Change in debtors		–500,000
Cash available		2,000,000
Monthly drawings	1,800,000	1,800,000
Partner income tax	1,200,000	1,200,000
Total drawings	3,000,000	3,000,000
"Make and take" ratio	100%	150%

Action needed?

Unless the firm has substantial cash balances, or bank agreement has been obtained, drawings should not exceed profits, so this ratio should always be less than 100%. If the firm has to fund any loan repayments the drawings need to take account of this.

Because the accounts profit takes account of changes in work in progress the apparent profit might not actually be available to take – it is a paper profit and may take several months to actually be translated into cash – so drawings should be constrained to the actual cash likely to be available. This is often a difficult figure to predict, but as a rule of thumb drawings might be restricted to 75% of profits. This also leaves some headroom for funding working capital.

It is very easy for partners to misunderstand the actual cash available for drawings and inadvertently start overdrawing and increasing the firm’s borrowings. If possible partners should try to keep their drawings within not just the profits as shown by the accounts, but the actual cash being generated by the business.

It can be hard to establish what this might be, but as the financial year progresses it might be possible to predict whether levels of work in progress and debtors are rising or falling and then take action to ensure problems do not arise.