Don’t bank on it

Law firms can no longer afford to countenance any lingering complacency when it comes to providing clear evidence of strong financial management.

By Linda Scott, The 360 Legal Group

The days of a managing partner requesting an increase in their law firm’s overdraft facility on the back of a telephone call are coming to an abrupt end.

The credit crunch and fallout from the partial nationalisations of RBS/NatWest and Lloyds/HBOS have led to much stricter lending policies by banks − in spite of the government’s efforts to make finance for business more readily available.

Banks are now seeking to identify potential bad debts in their lending books, leading to a change in direction and practice surrounding credit policies. And for the first time ever, this includes credit policies for the legal profession.

As a result of this closer scrutiny, however, banks are identifying a lack of financial acumen and control in a significant number of legal practices. This is particularly true of the traditional high-street partnership that either does not, or cannot, afford to employ a practice or financial manager − and where financial responsibility is allocated to one of the partners.

Unfortunately, solicitors aren’t necessarily taught how to run a business and deal with finances in their training. In many cases the partner dealing with finance may only be doing so because no one else wanted the role! Thus the financial control of smaller legal practices has often been managed using a secondary, after-hours, ‘fit it in where we can’ approach.

Call for evidence

On the other hand, in order to support and lend funds to law firms, banks increasingly want reassurance that practices are being run in a sound businesslike fashion, and that they are effective and profitable organisations (ironic, you may say, in view of the recent government bank bail-outs).

Banks will now look carefully at how a practice is run, by whom and with what support. For example, does the firm have a qualified legal cashier, practice manager or accountant to enable them to determine the effectiveness of the business?

They will also look more closely at factors that may impact on the future trading potential of a legal practice. These may include legal-aid contracts; costs information and costs estimates (an area where many firms are very vulnerable to action by a client if information has not been given or updated); interim billing; monies on account; staff appraisals; potential negligence claims; complaints procedures; IT back-up facilities, the results of Solicitors’ Accounts Rules (SAR) audit; anti-money laundering regulations, and so on.

Taken alongside how the firm is managed on a day-to-day basis, all of this is likely to be taken into account in deciding whether or not a practice is a viable proposition.

However, my-day to-day experience working with these law firms suggests that many do not have such basic, established, and sensible working-management principles in place.

An often-encountered problem, for example, is that there are no agreed income and expenditure budgets or costs-delivered targets in place, and therefore partners cannot produce effective management information that tells them whether their firm is profitable or not!

I have recently seen a case where a bank repeatedly requested monthly management information from a law firm, detailing actual vs. budget profit-and-loss analysis. After many months, the lender unsurprisingly lost patience and the partners have now had to provide full security to cover the overdraft facility in order for the bank to continue its support.

Increasingly, banks want far more financial information on a regular basis in the form of annual budgets; cash flow forecasts; projected profit and loss and balance sheets; aged debtors and creditors; details of hire purchase, lease and other loans; levels of unbilled and unpaid disbursements; the split of work (which helps to assess if the firm is too reliant on one area of work or one particular client); and updated partner asset and liability profiles.

In some cases, moreover, the banks are now trying to secure previously unsecured borrowing.

While we all agree that best practice and financial management are good ideas, is it really happening in your firm? And if so, is it also being reviewed and updated regularly? It is an absolute necessity for every business, including legal practices, to have sound financial processes, procedures and systems in place.

In order to demonstrate to a bank that your firm can meet their credit policy criteria, here are a few basic principles to consider.

Financial acumen

First, it is vital that the partners of a legal practice understand how the business stands financially. At least one of the partners (with or without the assistance of a practice or financial manager) has to know and understand how the business is performing financially on a day-to-day basis, so that in the event of a downturn, the business can respond effectively and quickly.

That individual should also have the knowledge, time and support to undertake what is effectively the most important role at the firm.

It is also helpful if at least one person in the firm’s finance team has an Association of Accounting Technicians (AAT) accounting qualification and an Institute of Legal Cashiers and Adminstrators (ILCA) qualification − and thus an understanding of the general requirements of financial controls and the solicitors’ accounts rules.

Second, there are a number of questions and considerations partners should take note of in order to prepare adequate information for their lenders:

Profitability

Do the partners know if the firm is profitable? What is the current position before and after drawings? How does this compare to the previous three years of trading? If there has been a decline or an upturn, what is the reason?

Is each department and fee-earner profitable, and has a profitability analysis been undertaken for
each department and fee-earner at the firm?

Accounts software

Can the firm’s existing system produce the information the bank may require?
Does it have the facility to undertake a year-on-year comparison without having to refer to year end printouts? Who within the firm actually knows what information can be extracted from the system − and how?
Does the system have online time recording for fee-earners?

Budgets and planning

Give yourself sufficient time to undertake a realistic review. Were your budgets and costs-delivered targets communicated to all your personnel in time for the new financial year?
In respect of costs estimates, are you confident that all your fee-earners are adhering to Rule 2 of the Solicitors Code of Conduct? Do they, as a matter of course, obtain money on account for disbursements and work to be undertaken?
When was the last extensive review of expenditure undertaken? Challenge every item!
How are costs-delivered targets calculated? Are they multiples of salary or chargeable hours per day? Are they calculated on an individual fee-earner basis or a departmental basis? How are the targets communicated? How are targets monitored, and how often? What action is taken if targets are not achieved?
Are existing charge-out rates profitable?
Is additional capital required in the coming financial year to finance a specific project?
What are the partners’ potential tax liabilities over the next 18 to 24 months based on the current year’s accounts? Have these been factored into the budgets and cashflow forecast?
Have VAT payments been factored into cashflow projections?
What is the procedure for paying supplier invoices? Who authorises the initial order and subsequent request for payment, and when are payments made?

Credit control

Who is responsible for and undertakes day-to-day management of the firm’s credit-control process?
Do you have a written credit-control policy that has been given to every member of your staff?
Is your credit-control process automated and linked to your accounts software?
What is the split between 30, 60, 90 and 120+ day debtors/disbursements?
How much has been written off so far in the current year, and have any further potential bad debts been identified? Who has the authority to write off bills, and have the reasons been recorded for HMRC purposes?

Management accounts

Do you produce regular management accounts in house and if so, how often?
Do you understand the information in the reports or, if your accountants prepare them, do you discuss the details with them?
Do your management accounts include a work in progress valuation? If not this will distort the profit/loss figure.
Do you review actual vs. budget figures at least quarterly, and record required amendments?
Have you had input or advice from your accountants, and do you provide them with copies of your management accounts?
How realistic are your management accounts compared to the year-end accounts provided by your accountants? (Your bank will rely on the information you provide and will take a dim view if there are detrimental anomolies between this and the finalised accounts).

Year end

Do you plan for the month-end/year-end? Do you know what information your accountants require so as to undertake the year-end financial audit?
How is work in progress calculated, and are you confident it is being captured correctly? Ensure you understand how your accountants have arrived at the figure in the accounts. This is an area that HMRC are investigating in a number of firms, and if not properly recorded, it could result in an additional tax bill, penalties and interest.
Ask your accountants to provide you with a detailed reconciliation between your management accounts and the finalised accounts.

Looking to the future: layering

In spite of the stringent lending criteria currently being applied, law firms will always be an attractive sector for the banks.

It is anticipated that new entrants into the sector, such as Santander, will cherry pick the best-run practices that offer little financial risk. Thus existing banks need to maintain a high-value proposition for their existing clients.

In fact, several are going to great lengths to improve their service, with specialist units being established to cater specifically for the legal profession and with an understanding of the problems being encountered.

HSBC, for example, produces a regular legal magazine giving practical advice on a number of different issues facing businesses today, while Barclays has a business-support service for firms encountering financial difficulties, and which aims to provide guidance and support and ultimately turn those businesses around. Lloyds/HBOS has a series of newsletters distributed via a dedicated legal
client website to provide assistance and guidance.

In addition, many bank managers now have a Lexcel qualification and a better understanding of the regulatory and compliance issues facing solicitors.

Layering the practice’s finances is an option that has largely been ignored by a legal profession used to the luxury of increasing overdrafts on demand.

Although some key players have gone from disbursement funding there will be new entrants into the sector, and it is likely that more law firms will consider employing alternative funding rather than their overdraft.

Whichever the chosen lending route, however, having excellent management information available will not only help to manage partners’ expectations, but also those of your bank/lender - helping to build a long-lasting and successful business relationship.

Linda Scott is both a former bank manager and law firm practice director, and is now a consultant with The 360 Legal Group. She can be contacted at linda.Scott@360legalgroup.co.uk