How to avoid ‘rookie’ errors in practice management
In navigating the turbulence caused by the age of coronavirus, lawyers should remember that “revenue is vanity, profit is sanity and cash flow is reality”, writes Anthony Hersch.
One upside of COVID-19 is that it has driven many firms to actively reassess practice management, and has helped place a spotlight on the importance of business planning and accurate forecasting. In the process, a lot of attention is understandably directed toward revenue. This, however, can provide a “false metric” of confidence if viewed in isolation of profit and cash flow.
There’s an old saying that “revenue is not earned until it hits your bank account”. And the timing of collections and expenses has a significant impact on a firm’s cash position, or “liquidity”. On this note, it’s critical to not only have a firm grasp of the firm’s numbers but to interpret them correctly and in context.
Consider these financial parameters to help pre-empt stressors and ward off unwanted surprises:
1. Revenue (billings) doesn’t necessarily equate to profit: When assessing past performance, or developing future forecasts, it’s common to focus on revenue as the primary measurement tool. This is compounded by its ease of calculation, and the “logical” metric to gauge success. Though, despite its prevalence as an accepted evaluation, revenue is ultimately a “vanity metric” – as it’s what’s happening “beneath” the number, to include the relativity of revenue in comparison to profit and the flow-on effect to available cash flow, that tells the real story.
2. Not all profit is equal: The true value of any business lies in its ability to generate profit – the difference between earnings and expenditure. Profit is usually monitored closely as it directly correlates with earning potential and growth. When considering profit, it’s imperative to understand that not all revenue will drive the same amount of profit, as different clients and types of work will present different profit profiles. It’s also important to distinguish between “gross profit” (revenue minus the cost of goods sold (including labour) versus “net profit”, otherwise known as the “bottom line” (the amount of profit remaining post all expenses, debts, income and operating costs). Counterintuitively, it’s possible (and relatively common), for a firm to generate tremendous revenue but have a net loss. This typically occurs when debt or expenses outstrip earnings. Accordingly, it’s prudent to review all resources to ensure maximum efficiencies and be open to considering alternative operations that minimise overheads. This may include reallocating resources for non-billing-related activities (such as outsourcing [or offshoring] administration, accounting, IT and/ or marketing), reassessing the traditional office infrastructure and associated expenses, or evaluating IT and its corresponding capacity to support a remote working environment. Where possible, it’s best practice to retain a portion of the profit as a cash flow buffer, despite the temptation to consistently draw down upon the asset.
3. Cash (flow) is king: In a time when credit is tight and liquidity is often dwindling, all eyes are on a firm’s cash flow as the “oxygen” needed to continue daily operations. Hence, cash flow is the critical metric for business sustainability and longevity. It’s also often the first sign of trouble if a firm is too reliant on less tangible assumptions associated with revenue and profit. There are various drivers of cash flow challenges in law firms, including delays in receivables, unresolved or disputed fees, disbursements required to progress a matter, reduced billings or unexpected overheads.
We encourage law firms to be proactive about their forecasting and working capital (cash flow) management, preferably in conjunction with an accountant. Particularly in such turbulent times, it’s recommended to review the firm’s financials quarterly at a minimum (though preferably monthly), and adjust business practices and expenditure accordingly.
Throughout this process, it can be valuable to “scenario map” various possible states of revenue, gross and net profit and cash flow, to remain on the front foot. It’s also wise to be aware of credit facilities available, as well as government-backed stimulus initiatives and tax exemptions.
Anthony Hersch is the chief operating officer of JustKapital.