A Financial Dashboard Shows a Law Firm's Speed – And If It Has Enough Gas

12/01/2013
From California State Bar: The Bottom Line, December 2013

Every law firm is a business and every business should know where it's going. Like the driver of a car, the lawyer should look out the window to see what's ahead (analogous to identifying new matters for generating additional revenue) whil glancing at the dashboard to make sure all indicators (in this case, of financial performance) are positive. Those who understand "The Business of Law®" refer to this as reviewing the financial metrics of the law firm.

Admittedly, today's financial information systems and software can and do produce extremely detailed metrics on financial performance. But such complexity of data raises the concern of conveying the information so that it is usable. Go back to the analogy of driving a car. All the driver behind the wheel wants to do is glance at the dashboard and see the speed, the efficiency of how the engine is running, and how much fuel is left. This "dashboard" concept can be applied to the benchmarked financial metrics compiled by software programs, with the key ones displayed in an easy-to-understand visual format for presentation to law firm management.

Information on the digital dashboard should be visually appealing, presented either as bar graphs or line charts. It should not try to display too much information on one visual – no more than the current 12-month trend plus the same month of the prior year is a good reference point. Use longer timeframes as appropriate.

The Dashboard Metrics

The dashboard glance at financial metrics should cover financial benchmarks that help law firms measure their business effectiveness by analyzing profitability, realization and cash flow. Lawyers who understand financial benchmarking can explore operating efficiencies in the firm, gauge the firm's performance relative to its financial goals, and better assess and reflect value to clients in their bills. For effective benchmarking, these measurements are paramount.

Benchmarking should focus first on profitability, reflecting the value creation dynamic of any business enterprise: Profits equal Revenues minus Expenses, in other words, P = R - E. Although this is a simple equation, there are a number of performance factors that underlie it to determine a firm's profitability, including:

  • Billing rates, whether hourly, blended (an average), fixed fee or other measure

  • Utilization, the percentage of a workweek (usually expressed as an annual average) that a lawyer actually bills

  • Realization, the amount of time actually billed and collected

  • Leverage, defined as the ratio of non-partners (associates, paralegals, staff) to partners.

  • Expenses, related to both operations and compensation, as a percent of revenues.

Billing rates are important, but should not be over-emphasized. The key to any law firm's performance is realization – collecting the money from hours billed. This realization is sometimes discussed in two levels: Billed to billable ratio (the percent of billable or booked hours billed), and collected to billed ratio (percent of billed work collected). The goal is to have a high collected to billable ratio. An overall realization of less than 85% is a recipe for trouble, because it means the firm has to treat 85% of its billings as 100% of its revenue.

A recent comprehensive statistical analysis by Georgetown Law School's Center for the Study of the Legal Profession, titled 2013 Report on the State of the Legal Market, showed that realization rates averaged 83.6% for all law firms studied. This figure is an historic low and some 8% lower than the 92% level at the end of 2007. For the 100 largest firms, the realization rate is even lower, at 82.8%. In a time of continued economic softness such numbers do not create a picture of good financial health, but they do show that remedial action is necessary.

Cash flow is the benchmark that ties these elements together. A rolling 12-month statement of cash receipts and payments is the third key element of financial benchmarking. This directly relates to collections. One study shows that a bill over 60 days past due can still be collected about 89% of the time. However, that drops to a 67% likelihood of collection after six months, and to a 45% likelihood after one year. A current cash flow statement highlights delinquents so the firm can move quickly to collect overdue accounts.

The Lawyer's Role

The most important goal of creating and evaluating a financial dashboard is to spot problems quickly and adjust the firm's activities so that financials remain positive. The dashboard concept shows that financial benchmarking and analysis needn't involve mastering management jargon or looking at things through the eyes of an M.B.A. Many lawyers, whose undergraduate and law school training had little practical business focus, think either they can't or shouldn't be business-minded. Even partners may not possess the business competency to calculate, or even understand, realization, utilization and similar metrics.

This is not to say that lawyers are oblivious to all financial numbers. The trend of national legal magazines publicly reporting annual financial information for the biggest law firms has transformed the profession's outlook. For the first time there was comparative data on revenue per partner, earnings per partner, and similar measures. Unfortunately, just like companies trying to impress investors and competitors, law firms began to make decisions based on maximizing revenue and profits per partner – and neglecting financial basics. But tracking the dashboard basics is what's truly important to keep a law firm vibrant and afloat – and this, not maximizing compensation, is the moral obligation of partners as owners of the firm.

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