Imagine you were on an airplane, and the captain came on the intercom and said: “Good afternoon, everyone. I wanted to let you know that the airline forgot to install the navigation system, I do not have a compass and the copilot forgot the map. This simply means that we are not exactly sure where we are. The last time we were sure was maybe about one hour and thirty minutes ago, so our plan is to keep flying until we see something we recognize. Once we see a familiar landmark, I will have a better idea of where we might be. So please sit back and enjoy the ride and be sure to check out the amazing snacks that we have for sale because this might take a while. Again, thanks for flying You Guessed It Airlines where we are never really sure where you are, but we try hard to get you somewhere.”
Just think how extreme this situation sounds, and then remember that this is a picture of how most lawyers approach the finance side of their law firm.
No explanation would satisfy you if you were on this You Guessed It Airlines flight. You would be rightfully angry and ready to file a lawsuit, post horrible reviews demand a refund and additional compensation. You and I would both say this is a disaster, but the interesting thing is most lawyers have no financial navigation system, financial map or even the basic financial tools to guide their business, but they expect their clients, contractors, partners and staff to just go along for the ride.
The simple truth about creating and running a financially successful law firm is that it all comes down to having the right tools, indicators and processes in place, so you aren't guessing your way through things.
Now let's see if we can get you off You Guessed It Airlines and onto Clarity Airlines because one approach is clearly better than the other.
If you are going to take a trip, one of the best tools to start with is a map because a map will help you see the big picture. When it comes to the finance side of your law firm, the best financial tools to help you understand the big picture would be the core financial statements. Your core financial statements consist of an income statement, balance sheet and cash flow statement. There are other statements but these three are the best for you to get a good overview of the financial situation of a business.
Probably like many of you, when I started traveling, GPS systems were not as common as they are today, so early on, my father taught me how to read an actual map. One of the important factors about reading a map is that you start by looking for relevant landmarks or some reference points so you can get a better idea of where you are. After you get a good grasp on your starting point, then you can start to plot a path that gets you going in the right direction.
When you understand how to read your financial statements, you will begin to see that they are a map that can lead you in the right direction.
Your income statement is a good place to start because it leads off with the metric you are probably the most familiar with––revenue. Your revenue gives you an idea of a few things like; Do you have a service that clients want? How many clients want what you have to offer? These are important questions because they help us define your starting point. For example, if your revenue is low, this tells us that our starting point is probably not a place where we want to stay for a long time.
After we address the basic question of your starting point, we want to see if you are headed in the right direction, so we need to look at your trend. If you look at your revenue over a 12-month time frame, this will help you understand your potential clients’ interests. If revenue is trending up, client interest is likely growing, but if it is going down, we likely need to take some corrective actions to adjust your course. For example, if your revenue is trending down, that could mean your marketing is unclear, or maybe your buying process is confusing and fixing these issues could change the direction in which you are headed.
Once you understand your starting point and your trend, another way to make revenue more insightful is to have a process for separating your revenue by case type. If we are going to figure out how to get you to your financial goals, it would be helpful to understand what specific types of cases are in demand more than others. For example, if you are a family law practice that provides different types of family law services, it would be great to know that 78 percent of your revenue comes from divorces that involve children. This additional detail could indicate that your marketing strategy or website should focus on potential clients that fit the profile of that type of case.
The next part of your income statement map would be your expenses. This gives you an idea of what you have been spending your money on. The key to making this part of your income statement useful is to have a process for creating relevant categories and sub-categories for the types of expenses in your business. For example, it would be helpful to know how much money you spend on growth expenses (sales, marketing and business development) or what your total people cost (employee plus contractor cost) looks like.
After you have a good idea of your categories and sub-categories, you can start creating simple metrics by taking your total expenses related to growth (sales, marketing, etc.) and dividing that by your total revenue. This growth expense vs. revenue will help you understand if you are using sales and marketing strategies that are working or are you just throwing money away. Here is an example of how the math would work; let's say your firm does $75,000 in revenue a month, and your total growth-related expenses are $15,000 a month (online ads, traveling to meet with prospective clients, Google ad strategy, podcast, and video content, etc.). Your growth expense versus revenue metric would be 20 percent. This 20 percent means for every $1 that a customer gives you, $0.20 goes directly to growth-related expenses, and the rest can be used to cover other costs in your business, and hopefully, some will be left over for profit at the end. If your percentage goes from 20 percent up to 35 percent and stays at that higher rate, that probably means you are headed in the wrong direction, and a course change could be necessary.
The good thing about this simple approach is that you can look at all the categories of expenses on your income statement this way (total expenses in a category divided by revenue). Once you calculate this ratio for all your expenses, you will have a good feel for where you are now, and viewing these ratios for the last 12 months will give you a better idea of the direction you are headed.
The balance sheet is another key financial map that will help you because this financial statement tells you what you own (assets), what you owe (liabilities) and what is left over (equity). To be honest, most law firms don't spend a lot of time on the balance sheet because there are typically only a few landmarks on this statement that are immediately relevant to running most law firms.
The first landmark would be cash. We have all heard the saying “cash is king,” so I tell law firms to think of it like chess: “When the king is down, the game is over.” That said, you want to make sure you are keeping an eye on your cash, which is the fuel that allows your business to stay operational. To get more value out of your balance sheet, here are two cash-related topics that you can focus on: your “cash trend” and your “cash cushion.”
Your “cash trend” will tell you if your cash is going up or down. Now cash could be trending up or down for several reasons, so think about the trend as the directional indicator that may require more research. To get a view of your cash trend, you want to look at your cash balance over the last six to 12 months. If you feel like your cash is very low and likely a problem, change your cash trend timeline to the last four to 10 weeks so you're reviewing a more current trend of data. After you understand your cash trend, you want to consider your “cash cushion” or, in other words, how much cash you have on hand compared to your normal expenses. A good rule of thumb I aim for would be two months or 60 days' worth of cash on hand. To figure this out, you would look at your average monthly expenses and multiply that number by 2, which means if something bad happened that affected your business, you have a 60-day window to figure it out and recover.
When you run a business, expect the unexpected to happen and plan ahead with an adequate cash cushion.
The next major factor on your balance sheet would be accounts receivable (AR). For many law firms this number may not exist on your balance sheet because you are using cash basis accounting, so you may have to look in your law firm management system or your invoicing system to find this number. The AR number tells you how much money your customers owe you. One way to think about AR is like this: AR is money that legally belongs to you, but right now it is sitting in someone else's bank account.
A best practice is to review your AR on a regular basis and have a process to follow up with customers that have an outstanding past due balance. Internally you should also have a process to flag cases with past due balances, and if you can ethically pause the work on those cases, do so. No one wants to fly on an airplane where the captain forgot to get enough jet fuel to successfully get you from point A to point B––this is why they have a process for check fuel levels before they start flying.
When you get down to the liability section of your balance sheet, the main thing you want to monitor is how much debt (credit card balance, loans, lines of credit) you have in your business. Depending on where you are in the life cycle of your firm (early stage, growth stage or mature stage), your debt levels will fluctuate. There are three big questions to ask: first, is this debt related to things that are helping grow the business; next, is your debt current or delinquent; and finally, what is the current interest rate on the debt. Debt can be a helpful resource that allows you to manage your cash flow while you navigate the ups and downs of your law firm, but you want to have a strategy and a process for keeping an eye on your debt.
If you use debt, use it wisely and have a plan for avoiding delinquency.
The last key financial map would be your cash flow statement, which gives you a better picture of where your cash is coming from and where it's going. Most law firms only look at the total cash number on their balance sheet and ignore the cash flow statement, but this could lead to a big mistake. Your cash flow statement breaks your cash movement into three buckets: 1. cash from operations, 2. cash from financing activity, and 3. cash from investing activity. Cash from operations is what the name implies, the cash that comes in and goes out related to the normal week-to-week operations (client payments, people cost, growth, overhead, etc.). Cash from financing activity would be the cash that comes in and out from debt financing agreements (loans and lines of credit). The cash from investing activity would be the cash that comes in and out of the business related to investors, owners and the firm's partners.
Knowing this distinction is important because you don't want to run a business that is trying to survive on financing or investing activities because, eventually, those sources of cash will run out, which means your business could be headed for trouble. The best practice and likely the only way for your business to survive long term is to have sufficient cash flow from your operations. When a business has sufficient cash coming from operations, that typically means they have customers who are paying their invoices, and the firm effectively manages expenses to keep them at an acceptable level.
Now whenever you think about your financial goals, you will know how to use your financial maps to understand where you are and how to find a few key landmarks to give you some context about your general direction.
When you are flying an airplane, you could fly from point A to point B with just a map because a map will point you in the right direction, but it does have limitations. The thing about only using a map is that you personally must see all the landmarks to know you are still on course, which means you can’t fly that high or too fast. The way that this compares to your law firm is simple; at some point of growth, you won't be able to personally manage every detail. You will hit a point where you want to grow the firm bigger and faster, and to do that successfully you have to rely on a few advanced tools called financial metrics or key performance indicators (KPIs). When it comes to the finance side of your firm, your financial metrics and KPIs are going to be a combination of both financial and non-financial data.
There are a lot of options for financial metrics, but a good place to start would be your growth and your operational metrics.
Your growth metrics are going to be all about helping you identify the indicators that can tell you if you will have smooth skies or turbulence ahead. Here are three key growth metrics: leads, conversion rates and cost to acquire a customer.
Leads are a common marketing metric that looks at the number of potential new clients that you can talk to about buying your services. The reason why this metric matters to your finances is because the trend will have a potential impact on your future revenue. If you are going through a period where your leads are down, this could mean that, eventually, you will experience turbulence ahead because your revenue and cash could drop.
Conversion rates are another common marketing metric that tell you what percentage of the leads become customers. This is a great one to keep an eye on because you want to know if the leads that you are attracting are saying yes to becoming paying customers. Now to really understand the potential impact, you will need to look at both your conversion rates and your leads together. For example, if your conversion rate is 65 percent and your number of leads is 23, you should expect about 15 of the leads to become paying customers. If your conversion rate increased to 75 percent, but your leads dropped to 19, you should expect about 14 of your leads to become paying customers.
Customer acquisition cost (CAC) is another indicator that helps you determine how much money you must spend to attract a new paying customer. For example, if your total growth expenses are $15,000 a month and you are taking on 15 clients a month, this means you have to spend about $1,000 to get a new client. This is very important because it will tell you how much cash you need to fund your growth expenses. For example, if you want to have 20 new cases a month, then you will need to invest about $20,000 in growth expenses to get there.
If you hired a marketing agency or a marketing consultant to help your firm, you should ask them to calculate these numbers for you on a regular basis. These metrics will hold them accountable, help you monitor the success of your growth strategy and prevent you from throwing money away on growth strategies that just aren’t working.
The operational metrics are going to be very similar to fuel economy ratings that help you understand things like how far you can travel (what is your capacity) and how efficiently your engine runs––your employee return on investment (ROI).
Capacity is a metric that many law firms ignore until they feel overwhelmed and the problem is already causing pain and discomfort. Most law firms are so focused on generating more revenue that they never stop to ask themselves questions like:
How many cases do I need to achieve my financial goals?
How many cases can my team actually support?
If we accept all of these new clients, can we get the work done effectively?
If you consider our airline example, this would be like a captain agreeing to carry a large amount of cargo without first understanding the capacity of his airplane. All of us would say this captain is either inexperienced or a bit reckless.
Do yourself a favor and take the time to understand your firm's capacity so you can plan. Law firms that don't properly assess their capacity eventually make poor financial decisions because they rush the hiring process and agree to compensation packages that are too expensive to sustain, overpay for contract support to fill last-minute gaps or overwork their team, which can eventually lead to high turnover.
The last advanced indicator we should cover is the efficiency of your staff’s performance also known as your ROI. This indicator allows you to compare the total cost of an employee versus the total revenue that the employee generates. A good rule of thumb would be to aim for an employee ROI of three or more. For example, if the total cost of your associate is $120,000 a year (post-tax and benefits, bar dues, training, etc.), and that associate generates about $252,000 in annual revenue, the associates' employee ROI would be 2:1. This means the associate is probably not generating enough revenue to cover their direct cost plus contribute to the overhead cost of the firm. In this example I would guess that the firm would eventually have to cut back on overhead costs, the owner may have to reduce their compensation, or the financial situation of the firm will get a little more uncomfortable.
Now for the rest of the time that you run your law firm, remember that imaginary airline You Guessed It Airlines, where they fly blind and just hope things eventually work out. Yeah, don't run your law firm that way; get a clearer picture of your financial goal, then use your financial map and proper indicators to help you navigate your journey so you can safely arrive at the financial destination of your choice.
