Avoiding the downwards spiral towards financial failure

All businesses need to consider two factors when assessing financial stability: profit and cashflow. A business can be making a profit but not be able to generate sufficient cash to meet its needs. '¨On the other hand a business with sufficient cash reserves might actually be unprofitable and depleting its reserves. Both types of instability can be remedied, so it is very important that the early warning signs are identified and acted upon quickly by management before the symptoms create a downward spiral towards failure.

CASH STARVATION

There are two principal causes of cash starvation in profitable firms: not being able to turn profit into cash quickly enough or, using the available cash more quickly than it is being replaced.

The traditional method of measuring a firm's effectiveness in turning profit into cash is measured through ratios such as lock up, i.e. work-in-progress (WIP) and debtor days. This ratio gives an indication of how long it is taking for a firm to convert an hour's work into cash in the bank. The ratio is usually expressed as a number of days' sales that are tied up in WIP and debtors. Firms can quickly become unstable if they do not have strong controls over these ratios.

Another way of measuring cash resource and stability is to calculate the firm's working capital headroom. This is found by computing the firm's monthly costs and calculating how many months costs could be financed before the bank facility was breached if no more cash came in. Firms which do not have sufficient headroom for the swings in cash collection cycles can very easily become financially unstable.

IMPROVING STABILITY

Profits and cash are not the same thing. Drawings are taken from profits earned but often partners want to take drawings before the profits have been turned into cash. If partners continually take drawings before the cash has been generated there will come a point where the bank overdraft and creditors cannot be stretched any further.

Insufficient profits may lead to financial instability. How much profit is sufficient depends entirely on what the partners want to earn. If the business earns less than the partners require then the firm will be heading towards financial instability. Fortunately it is not inevitable that a poorly performing business will become financial unstable. Identifying that there is a performance problem as early as possible is the key to avoiding financial instability. Corrective measures can then be taken.

ACCESSING FINANCE

The type of finance used by a firm should match the underlying need. Long-term finance should be sought for long-term needs. For most law firms the sources of finance are usually:

 Partner capital introduced (probably provided via personal loan to partner from bank)

 Overdraft

 Term loan

 Asset finance

 Secondary finance market

Many firms find it difficult to quantify partner capital levels to assess the appropriate finance levels for their business. The amount required is a function of two things: the credit the firm is prepared to give (and take) and the headroom the firm is prepared to work within.

However, in practice the amount of capital is often determined by how much the bank is prepared to lend based on an assessment of the business, the overall debt position and for some firms the net assets of the partners.

The bank is the funder many law firms have tended to turn to their first when they need to access additional funds. In the past banks were the obvious source of additional finance and would normally have been very happy to accommodate firms. It is not automatically assumed that all firms of solicitors are reliable borrowers.

CONSEQUENCES OF FAILURE

An unplanned cessation of trade will lead to the SRA taking steps to protect the clients of the firm by way of an intervention. The costs of this are for the account of the firm's partners. These costs will not only include the costs of collecting and protecting client files but also the costs of returning them to the client. This isn't restricted to live files and extends to all the closed files in storage accumulated over time. This can be a very significant cost indeed.

Any appointed insolvency practitioner will also review drawings taken by partners and request repayment of overdrawn current accounts. Any creditors who have been granted personal guarantees will be requesting repayment proposals. At the same time the providers of equity loans will be seeking repayment and the partners looking for new roles.

CASHFLOW AND PROCESSES

The most effective measures to keep cash flow under control are:

 to identify the working capital requirements '¨in advance (based on the credit policy the '¨firm adopts);

 slavishly control the credit the firm gives, and;

 ensure there is sufficient headroom at '¨all times.

Costs and drawings must both be controlled. In addition, firms ought to consider how they could improve business processes. There are essentially three ways to improve performance:

 reduce the overhead cost base of the firm;

 increase the average transaction volumes '¨and values (Revenue Performance Improvement), and;

 increase the effectiveness of each process in the business (Business Process Improvement).

Initially, most firms find cost cutting easier than RPI or BPI but research shows that both options are usually far more effective than cost cutting in the longer term.

HOW MUCH OF WHAT FINANCE

There is no single correct answer to this. Some firms still operate without any bank finance whatsoever. But this doesn't guarantee financial stability. Instability comes from being starved of cash and this has various causes.

Firms must actively quantify their working capital needs and weigh up the pros and cons '¨of each source of business finance. They then '¨need to speak to providers of finance (both internal and external) and explain the needs well in advance so that they can secure the amounts necessary or alter the business plan accordingly.

It is crucial that financial issues are '¨identified early and then formal business, '¨legal and insolvency advice taken as this '¨allows the broadest range of solutions to be explored and implemented in a timely fashion. This will provide the greatest opportunity to '¨avoid doomsday. SJ