The Top Three Financial Priorities For Law Firm Management in COVID Times
The global pandemic continues to cause havoc for businesses all over the UK, and the legal sector has been affected in many ways. Cash flow for example. Cash flow is historically a significant factor in law firm failures, as it is for many businesses. It is well known that cash flow is the number one reason businesses fail. Research (2019) from Xero and PayPal reveals over 1/3 (37%) of small business owners have considered closing their businesses in the last year alone due to problems with late payments.
For legal firms this is partly due to the partnership model. As profits are distributed to partners, law firms tend to have relatively low cash balances. Other liquidity challenges relate to the nature of legal work: lock-up (unpaid bills) and work in progress (WIP). According to the Law Society’s legal benchmarking report, the average number of lock-up days for law firms of all sizes is 155. In addition, an HSBC survey of mid-market law firms reported that firms anticipate this increasing by 15-25 days for the first six months of 2020. And due to COVID in reality the number was likely to be higher than this.
Law firm revenues have been falling amid the Coronavirus squeeze. According to the HSBC survey, firms are forecasting a significant 10-20% fall in revenue for the 2020/21 financial year. But it is true to say growth was already slowing before the pandemic according to these figures: the UK legal sector generated revenues of £9.34bn in the first quarter of 2020, down 6.6% on the last quarter of 2019. This is worrying.
In summary in part to Coronavirus, law firms of all sizes are dealing with a liquidity crisis, and like the pandemic this is a global phenomenon.
Top three priorities for Law firm financial management
Right now, law firm financial management needs to focus on three priorities:
1) Repositioning for post-lockdown recovery, profit and growth.
2) Financing for short-term survival without taking on major long-term debt.
3) Making sure that whatever action is taken now does not damage client relationships and new business development.
In such uncertain times it is prudent firms should do a range of cash flow projections based on different scenarios and monitor performance against those scenarios. In short this is normally a combination of producing long, medium and short-term forecasts and monitoring and updating on a regular basis (every month for example). It is still very clear today that nobody knows how long the COVID restrictions will continue, so such scenarios should include different time frames as well as the possibilities of late payments and, it’s sad to say, business failures among clients and suppliers.
Liquidity, or access to working capital, is a key concern, as debtors and WIP will not pay the bills. Some organisations have renegotiated debt repayments and/or extended credit facilities. Many firms have had to top up their revolving credit facilities and have taken on additional debt to provide greater liquidity in the face of the current challenges in 2020.
The Government’s Coronavirus Business Interruption Loan Scheme (CBILS) and the Bounce Back Loans have been useful to some, but the schemes are limited to SMEs. Many firms have had to look elsewhere such as increasing their overdraft facilities and/or seeking commercial finance.
In 2020 even on the back of a good financial year most firms will have to completely recast their financial assumptions going forward and will need to scrutinise their financial health much more closely. 2020 really has bought to a head the need for a live, adjustable business plan ensuring a firms financial model is accurate, nimble and robust as well as offering a roadmap to what changes and challenges company’s needs to consider, mitigate and act upon. Like never before financial forecasting is playing an important role in a firm’s strategy and decision-making.
Measure and manage
It is very important all the financials in firms are measured and managed.
One such ‘test’ is the Quick Ratio for the ultimate test of liquidity. This is fairly simply calculated by dividing liquid current assets by total current liabilities. Liquid current assets include cash, receivables and marketable securities. The higher the ratio, the greater a firm’s liquidity.
The Quick Ratio ignores work in practice (WIP) when comparing liquid assets (cash and debtors) with creditors due. This is why some law firms – and many businesses – hit a brick wall at the end of March. They didn’t have immediate access to funds because of their cliff-edge liquidity and lack of cash reserves.
Firms with a Quick Ratio of less than 1:1 technically could not pay their debts at this time so, business models based on a continuation of business as normal, which disappeared in mid-March, suffered when transactions almost instantly dried up.
Strategic approach to WIP
For smaller firms, tighter cash flow management is key to survival. For example, with conveyancing firms dealing with landlords and suppliers was an important factor in controlling cash during the early days of lockdown. Agreeing payment holidays and delaying terms was part of the strategy. Chasing down outstanding debt was, and always should be, also essential to cash flow improvement. This year many firms have recognised that their credit control policy was not as tight as it should be and have over lockdown moved to a model which reduced the large amounts of WIP and debtors. The same of course applies to larger firms as well as small.
It is clear moving forward firms need to maintain financial hygiene by time-recording, prompt billing and collection procedures. There will need to be some flexibility with some clients however, especially in leisure and retail. They might be in real difficulty and if you are not flexible and showing empathy in time you risk losing these clients.
Partners own the business and need to appreciate that they benefit in the good times and don’t in the bad times. It is clear if a firm is struggling with generating income or with cash flow partnership firms should manage partner distributions to preserve cash and possibly link future partnership distributions to cash flow. Magic circle and many other large firms have indeed delayed or cut partner profit distributions to retain cash. Allen & Overy was the first to call for partners to contribute capital as well as delaying bonuses and pay rises for associates and support staff.
Many firms have either had to cut pay and working hours, and/or furlough staff. Inevitably redundancies loom for some firms to reflect falling revenues. Clearly now the first lockdown has lifted some redundancies might have been avoided but only if the firm has ‘pivoted’ their business and put measures in place to streamline their firm and its cash position.
Expense reduction is crucial which is why many firms are looking at their office requirements given most companies operated very successfully with employees working well from home. Office space is often a law firm’s second-highest expense, after employee pay and has traditionally represented a significant and key fixed cost for legal firms. Because firms have discovered they can operate effectively with lawyers at home, many will seize the opportunity of developing new working practices and reviewing ongoing space requirements.
At the very least it is worth remaining flexible and not getting locked into long-term arrangements. As far back as late May Slater and Gordon said it was set to ditch its Holborn office in London, where around 200 employees are based, once its lease is up this month (September 2020), as it looks to embrace permanent remote-working. But it hopes to find a smaller office space to host in-person meetings.
Discretionary spend is likely to shift too, particularly as firms physical requirements are changing. Simply put - if in doubt don’t spend.
Another important consideration is that some law firms (and other businesses) have not yet experienced the full impact of Covid-19 on their balance sheet – or their operations. Many law firms in the UK have an April year end so they should have been reasonably cash positive when the pandemic hit. In addition, in recent years legal firms’ have been tending to increase partner equity and their bank facilities to give themselves extra breathing space when it comes to cash flow. Those that haven’t are undoubtably now feeling the pain. Given the economy has been pretty buoyant over the last decade many firms had been preparing for a downturn, but I doubt any were expecting what has materialised this year.
However, this has its benefits. The shifting regulatory landscape has and will continue to produce new instructions for legal firms. Sweeping new regulations have been introduced, contracts scrutinised across a raft of industries, both to deal with situations arising as a direct result of the current pandemic and to future-proof businesses against future similar scenarios.
Cash flow is king, they say. And cash flow is of course important not only now but as business recover and grow from the pandemic and businesses start to pick up costs again and cash may still be constrained. It is possible the worst cash flow problems have or will come when the main pandemic is over, and things are returning to what is being termed ‘the new normal’.
The furlough scheme has been welcome and generous. It gives firms time to consider their options and to avoid knee-jerk decisions. However, it will start to be reduced, so firms need to develop clarity as to their staffing and to communicate that clearly and fairly.
It is generally known the last thing you should do come recession is reduce your marketing budget. The same applies to the pandemic. Cost-cutting might be the easiest way out in this respect, but it is not the way to build for the future. Companies will have to focus more on their marketing and business development to maintain cash flow. It is this ability to feed their pipeline that will enable those on furlough to return to work, redundancies minimised, and the current customers serviced to a level they expect.
With the pandemic seemingly now to be here into autumn and winter and localised lockdowns already a reality at the very least law firms who have so far pivoted need to review on a weekly if not daily basis. Those that haven’t planned and adjusted need to take urgent action to do so otherwise suffer the consequences. End/
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