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Efficiency failures putting UK law firms at risk

Flat profit margins and high lockup weakening financial stability, survey finds

16 March 2015

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By Manju Manglani, Editor (@ManjuManglani)

Small to mid-sized UK law firms have enjoyed a year of sustained economic improvement, according to a financial benchmarking report released today.

The survey found that, while fees and profits were up across the board, firms had failed to convert these into higher profit margins.

"Improved revenue and profit levels are welcome, but profit margin overall remains flat, suggesting that improved efficiency was not a business focus in 2014, with many firms stretched and challenged to cope with increased instruction levels," said Steve Arundale, head of professional services at NatWest and RBS, which produced the annual report.

"It is key that firms manage their business processes to become as efficient as possible in order to maintain or improve profitability. Firms need to be better at protecting themselves against the revenue peaks and troughs that are influenced by shifting economic conditions."

The third annual benchmarking survey received responses from 339 law firms from across the UK and with revenues below £35m.

Growth in revenues and profits

Fees grew by five per cent on average in 2014, up from the three per cent growth recorded in 2013, equating to medium fees per equity partner of £473,000.

Median fees per fee earner were £138,000 - a notional increase of £2,000 on the previous year.

Profits increased by eight per cent on average, with the median profit per equity partner increasing by £20,000 year-on-year to £107,000.

London-based equity partners remained at the top of this group, earning £271,000 on average, up £25,000 year-on-year.

Fees per London equity partner were also the highest in the UK, at £870,000, but average fee growth was four per cent, making it one per cent behind the national average increase.

Scottish law firms achieved a five per cent increase in revenues in 2014, resulting in the first time in three years that they achieved an increase in profits.

However, equity partners in Scotland fared the worst in the UK in terms of earnings, taking home £84,000 on average.

Typically, partners in Scottish law firms maintain a larger capital position than other regions, but the level of debt against capital remains higher than any other region in the UK.

Law firms in the southeast recorded a three per cent year-on-year increase in revenues.

Equity partners achieved median fees of £439,000, while fees per fee earner fell by £5,000 to a new median of £130,000.

Research suggests that firms in the southeast have increased their number of fee earners without focusing on efficiency or profitability, according to the report.

Law firms in the southwest increased revenues by four per cent and profits by seven per cent. Median profits per equity partner grew by £20,000 to £93,000 in 2014.

Profits at law firms across the midlands and Wales were up five per cent in 2014. Improved economic conditions supported annual revenue growth of five per cent, with fees per equity partner reaching £457,000.

Rising lockup a continued problem

The report also identified a slight increase in lockup, up two days to 109 days on average.

Smaller firms were typically better at managing this, recording a median lockup of 91 days, compared to 125 days in medium-sized firms and 132 days in large firms.

Firms in the southwest were amongst the best at managing work-in-progress and debtor days, with an average lockup of 91 days.

Many firms are predicting a reduction in lockup days during 2015, although advisers to the legal sector do not share that optimism, suggesting that additional work can be undertaken to improve cash generation.

"The vast majority of legal firms fail to manage lock-up effectively, and consequently provide far too much credit to clients. This, in turn, can potentially generate cash flow problems," the report notes.

A little over two-fifths of respondents said they anticipate improved work-in-progress days and debtor days.

The research found that firms are also failing to manage their overdrafts effectively. On average, spare capacity in overdrafts was at 11 per cent of annual fees, with little variance in this number among firms of different sizes.

This suggests that firms would run out of money in about 40 days if they received no further money from clients during that period.

"Many firms could face cashflow challenges associated with lock-up, despite increasing levels of work," warned Arundale.

"In order to preserve financial stability, legal firms must stay in touch with their cash position, and cash budgeting is more important than profit budgeting."

Sustained optimism for the coming year

The research found there is sustained optimism among law firms about their performance prospects over the next 12 months.

Four-fifths said they expect fee income to grow and 30 per cent said they expect revenue growth to reach 10 per cent or beyond.

In addition, 69 per cent believe profit levels will improve and 68 per cent believe chargeable hours will increase.

However, operational efficiency continues to be a challenge, with two-fifths of respondents expecting their profit margin to remain unchanged or to decrease.

Another challenge facing law firms in the coming year will be cyber security, according to the report.

"Although risks associated with the economy may have diminished, risks associated with criminal activity have increased significantly over the last 12 months," warned Arundale.

"Criminals know that legal firms carry large cash positions via client accounts. This represents a great opportunity for criminals to try and compromise a firm's security arrangement in respect of their electronic payment governance."

The full results of the research are published in 2015 Financial Benchmarking Report - Law Firms.


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