Firms must understand how they perform in light of other firms’ performance and sectoral trends to maximise their own gross margin, says Chris Marston
January may be the traditional time to set ambitions for the coming year, but supporting firms in our member-owned network with a toolkit focused on the future is top of my list throughout the year. Our latest data shows the top priority for LawNet firms in 2020 will be to streamline their processes to maximise efficiency, closely followed by management of staff performance and cash flow. If you know what you need to target, you can act; but identifying what needs to be tackled is often the first and biggest challenge. Most law firm leaders are keen to understand how their firms are performing.
When the end of year accounts are reviewed, comparisons will be made against the previous year’s outcomes and the budget that was set for the year. If the firm has articulated its medium-term strategic objectives, it will be possible to also assess what progress is being made towards those goals. So far so good. But to ensure the business performs as strongly as it can, firms need to understand how they shape up in terms of the trends and the sector generally. As Chris Murratt, chief executive of Nottingham member firm Actons, explains: “It is important that performance is not viewed in isolation. You might have had a very good year, but if everyone else had the same increase in profit then you have not exceeded the market, you’ve just kept up.” This is where benchmarking comes into play: enabling you to move from inwardlooking assessments to being able to judge how your firm stands in the sector at large; and using this to focus attention and drive action in key areas. We see the value of this sort of holistic approach within the LawNet membership. Each year members are asked a range of questions in our annual benchmarking survey covering financial performance, people structure, financing and practice management.
This is undertaken independently by the specialist legal team at chartered accountants and business advisers PKF Francis Clark, who merge the resulting information with data they collect from the wider UK legal sector. This enables firms to compare their own performance with others in the member network and beyond. To complete the circle, this knowledge is used to support firms in developing future strategy. The value of such an approach is endorsed by Murratt: “We look at all the national surveys to get as big a picture as possible, all of which provide valuable intelligence, but with the network’s research the raw data is translated through an interactive process. “We receive personalised reports and have a group session to review the findings, with practical support on how to tackle the key issues. This makes all the difference in how we can use the knowledge to drive the business forward.” This is borne out in network performance figures. Andrew Allen leads the legal sector team at PKF Francis Clark. He explains: “Benchmarking can help firms to see trends when results are based on reliable data that is relevant to a firm’s profile, but the biggest value comes through structured follow through, where the knowledge is used to focus on improving future financial strategic thinking and planning. “Results from this year’s LawNet bench marking reflect overall financial performance ahead of UK-wide law firm averages, with strong results in fee income growth. Alongside, people costs have reduced, where many firms in the sector have been struggling against increases in this area combined with productivity declines.” Not all firms can access individual guidance from sector experts like Allen, but studying the results of sector-wide research to undertake your own comparative study and discussing this with your accountants is valuable.
Even the act of seeing what analytics are needed to answer all the questions can be informative. If it’s on the list then it is something that forward-focused firms are acting upon – so if you’re not measuring it, you can’t compete or improve on it. In terms of what is measured, professional services businesses like to talk about profit per equity partner (PEP) and that’s certainly the most commonly quoted ratio among the top City firms. However, there are plenty of other areas worthy of examination, where even marginal gains can transform performance in a surprisingly short time span. The most important metrics concern profit and cash – without these any business is heading for extinction – but efficiency measures and utilisation of human and other resources are equally important. Our surveying is broken down into five key areas: income, people, expenses, profit and working capital. And we compare the figures year-on-year. Historical data can help shine a light on areas that might otherwise pass unnoticed.
As David Snodgrass, finance director of East Anglian LawNet firm Ward Gethin Archer, says: “Taking part year-on-year gives an opportunity to see where things are changing, positively or negatively. Being able to track against comparable firms is also useful as we are often in the upper quartile of firms of our size, so if we are not performing at that level in a particular category we will investigate to understand why.” Our survey comprises a relatively small sample group. However, our member firms share a commonality that may be missing in the bigger surveys, such as the NatWest and Law Society reporting, while benefiting from the comparative data of the bigger picture of the UK sector that PKF-Francis Clark brings. As Snodgrass says: “Having a group of like-minded law firms to compare ourselves against makes it more relevant than some other financial surveys.” But while figures provide a baseline, (whatever the source of the data being considered), firms need to interpret this against their own profile and customer base. Snodgrass continues: “Our spend on marketing has been much lower than the average LawNet firm which prompted us to consider increasing spend, but we were cautious about taking action without a strong sense of what we were going to achieve. We spent time reviewing the services we wanted to promote and in what locations, and then launched targeted campaigns to increase awareness of our brand and services.” Alongside the statistical data we collect, participants are asked to name their key challenges for the future.
The resulting anecdotal information is collated into rankings and compared with the sector overall. This is invaluable in guiding our network programme of practice support for the coming year, as well as helping firms identify trends for focused action. As Murratt explains: “Knowing that others were struggling with recruitment in recent years helped provide reassurance of our own experience and supported our decision to allocate extra expenditure to tackle the problem, with success.” Recruitment was the top priority across the network for a number of years, but the latest statistics show headcount growth stabilising and a reduction in recruitment fee expenditure (except in a couple of areas such as private client teams and certain areas of litigation). So where are sharp eyes setting their sights for the coming year? As Allen comments: “The results are interesting and certainly reflect our broader experience of a shift in the focus of firms towards process improvement. It’s about getting the engine working better.” END GAME With efficiency and productivity having a prominent focus in many firms, we have seen investment of management time looking at factors such as time capture, matter process management and client management training for fee-earners.
Firms are revising the shape of management information and how they monitor key performance indicators (KPIs). The end game is increased gross margin. People costs in relation to fee income is a core measure of productivity for law firms and a primary indicator of profitability, so it is important to assess where you stand on salary costs as a percentage of fees. Across the sector this is generally between 45 and 55 per cent; and it is useful to extend that to include notional salaries for equity partners, for which the sector is reporting in the order of 55 to 65 per cent. Fee income per fee-earner is one of the most crucial financial KPIs for law firms. It is a key measure of productivity and small improvements can make a significant different to PEP in an average partner structure. It can be affected not only by the size of the firm and its geographical location, but also by the types of work undertaken, so looking at productivity by department is a useful drilldown exercise.
The other factor which has a significant influence on PEP is the employee/partner mix. In general, a law firm with a higher ratio of fee-earners to equity partners will generate stronger profits. As with fee income per feeearner, it is useful to drill down to department level. Are there more fee-earners per equity partner in different work types? Certainly, that is usually the case and may influence where future growth is targeted. The ratio of support staff to fee-earners is another important aspect of profitability; and the extent to which support staff enable feeearners to focus on fee earning can be crucial. Generally, we are seeing incrementally fewer support staff in traditional roles within firms, and as IT investment continues it is likely that numbers will further reduce over time. However, many firms are already finding that such roles are being replaced by specialists such as marketing, human resources or software programmers. We are seeing higher tech spend across the network. More complicated systems require specialists to operate and develop them, as well as new hardware and software such as practice management systems (PMS), client portals and time capture. Generally, there is a correlation between tech investment and PEP growth.
The other priority we are seeing is cash management. Many law firms have been reporting cash reductions, leading to a review of external debt and capital funding arrangements. This is due to factors such as retiring capital funding partners, variable financial performance and increased capital and overhead investment. Together with increasing volatility in activity levels and general economic uncertainty, it is important for firms to keep control of lock up and avoid additional stress on cashflow. We’ve seen impressive progress on lock up across our member firms in recent years, such that they are recording better rates than the sector generally.
But there is never room for complacency: all firms need to monitor this carefully as even a small drift can generate a considerable cash funding burden. For example, an extra 11 days of lock up in a £5m turnover firm would effectively require a further £150,000 of cash funding. Lock up is correlated with the mix of work undertaken by firms, so should be assessed with that in mind. Some departments may have cases that take a long time before they reach the point of billing, such as personal injury, and it’s important to factor that in when comparing your position. That personalisation is an important takeaway. Comparative data can be a valuable tool in driving strategic development, but it needs to be relevant to your firm.
There may be a commonality with those taking part, as is the case with our discrete member group, but drilling down to find the detail that matches your profile is essential. One thing we can be sure of as we enter 2020 is continued economic uncertainty – making strong strategic planning and detailed financial awareness even more important. Taking the time, as the foundation of this year’s business planning, to compare your performance and to identify the trends that will have most impact on your firm will stand you and the sector in good stead.