Getting your house in order is a first step to financial stability

Recent failures including Follet & Stock, EOS and Linder Myers have brought the need for financial stability into even sharper focus for practices that are optimistic about the future. For many SME law firms, the future carries significant uncertainty, with at least 1,200 identified by the SRA as having evidence of financial difficulty.

Many firms have implemented a programme of financial control; the introduction of basic principles of credit control, tight working capital management and reducing wasteful and surplus expenses are long overdue. However, if most firms have now pursued these 'hygiene' policies to the likely limit and are still having problems, then more fundamental questions need to be asked. The very 'health' of the firm has to be examined.

Many areas of legal work can be readily benchmarked against best practice across a range of indictors - profit margin, lock-up, fee earner to support staff ratios and caseloads, to name but a few. This gives a good indication as to whether poor results are due to slack in the system which can be solved by better management (hygiene) or whether the business is unlikely to return to a stable level of growth (health).

We are increasingly seeing firms where their basic business model is not robust enough to bring about the cashflows necessary to pay down debt and allow the partners an income. In these cases, a major strategic re-appraisal is required - and often before the cumulative impact of a series of poor financial results leads to the risk of distressed outcomes such as insolvency or a fire sale of assets.

Financial strategy

The key constraint for law firms in today's market is the availability of funding. In large part, this funds working capital - unpaid bills, disbursements and unbilled WIP. Typically, SME firms will have 75 to 90 per cent of their net funding applied to these balance sheet items. Trying to grow the business to solve a problem of over-borrowing is therefore likely to make the situation worse, not better, due to growing working capital requirements.

Higher fee income (and hopefully profits) will not necessarily help a law firm to manage its cash requirements on a strategic level. In today's market conditions, the volume of business should be geared to the amount of credit available to fund it. This pre-supposes that all lines of business and all clients or jobs are profitable. In no law firm is this the case.

The starting point for any review of financial strategy has to be a close examination of real profitability. The vast majority of SME firms have only a very hazy understanding of how to analyse and measure profitability, and how this changes over time and relates to funding requirements and risk management.

Reshaping a practice

Understanding the underlying financial dynamics of a law firm is a prerequisite to developing a credible strategy, but is only the start of the process. Existing business models are being challenged as never before by the impact of new competition, web-based technology and the harsh economic climate. Perhaps as many as half of all law firms will not have a viable future unless they radically change direction.

Reshaping a firm involves stopping doing certain things, improving and changing other things and starting to do new things. There needs to be clarity about which client groups are to be serviced and in which business areas and how. There should be an equal commitment to what the firm will cease doing or not attempt to do. Such analysis and decision making is difficult for nearly all law firms - particularly those with multiple offices, departments and specialisms. It involves challenging history, culture, powerful personalities and values.

It may be that, as part of this process, a firm fragments. This is not necessarily a bad outcome, but must be managed as part of a controlled process. There may be no natural synergies between certain groups of clients and services. A key question must be: "If you were starting out today to build a law firm, would it look like yours?"

A reshaped firm has a much better chance of a merger or of being acquired on good terms than one that lacks focus and the will to change. Merging or being acquired without having done this work simply leads to someone else having control over the process and an effective dilution of terms - purchase price, remuneration and influence - and usually residual liabilities.

Not getting your house in order is a recipe for a disastrous future.