For those law firm leaders who understand the value of running their firms like businesses, fiscal year-end financial planning is an exercise these business-savvy leaders have no choice but to engage in. Without financial planning and the ongoing monitoring of financial performance, firm leaders are gambling—blindly—that their firms will stay afloat in the coming year and beyond, no matter what their competitors, the economy, and society throw at them.
Financial planning also complements a firm’s strategic planning. The former helps a firm determine what is possible with the latter. Whether a firm is looking to move into new markets, invest in its marketing or infrastructure, bolster its headcount, or do something else entirely, the strength of a firm’s financial footing, and its ability to predict how that footing may change over time, will determine how much a firm can execute on its strategic vision.
Since our founding, the leadership team at Pond Lehocky Giordano has incorporated the following four key elements into our year-end financial planning process. While our mix of legal practices—plaintiffs’ side workers’ compensation, disability, and general injury—may differ from the practices at your law firm, we believe there are four pillars of any law firm’s year-end financial planning process.
In this first article in a two-part series, we discuss the first two pillars.
Pillar #1 – Reviewing the Current Year’s Performance
All law firms should generate financial reports and use a set of Key Performance Indicators (KPIs) in evaluating the financial performance of their practices.
Law firm leaders should begin their year-end financial planning process by collecting year-to-date financial reports and metrics for the current year, including profit and loss, balance sheet, and cash flow reports, as well as any other managerial reports their firm may generate. Firm leaders should view these reports in a year-over-year manner to identify any changes, both in dollars and percentages. If their firm has previously generated revenue projections and budgets, firm leaders should review them and create a variance analysis that compares the actual numbers to the expected numbers, and then determine how severe any variances were and how they can improve their models for next year.
Once a firm’s leaders have compiled their firm’s financial reports and KPIs, they’ll want to answer questions like the following, depending on the kind of practices they have:
– Why was revenue higher (or lower) than expected?
– Why were expenses lower (or higher) than expected?
– Why do we have more (or less) cash than expected?
– Why was our average fee higher (or lower)?
– Why was our success rate on our matters lower (or higher)?
– How many hours did we bill, and how does that figure compare to what we expected?
– How many hours billed were for recurring matters versus onetime matters?
– How many hours did partners bill as a group? How many hours did associates bill as a group? How do these figures compare to what we expected?
– Which practice areas were most profitable and least profitable? Why? Did this change from last year to this year?
– What’s our average realization rate?
– What’s our average collection rate? What’s our average time for collections?
– How much in fees did we write off?
– What do these answers tell us about what we did right and what we did wrong regarding our firm’s operations?
If firm leaders can answer questions like this, they’re in an excellent position to move forward with their financial planning. If they cannot, they should dig deeper into their data before moving forward.
Regarding revenue projections and budgeting, which are more forward-looking, firm leaders should evaluate both the accuracy of their planning models and the nature of the expenses.
As to revenue projections, if higher revenues were caused by a higher average fee, firm leaders should determine if this was because of a onetime outlier in the form of a particularly complex matter or a particularly high settlement or verdict.
When reviewing the budget, firm leaders should always be on the lookout for extraneous or unnecessary expenses they could eliminate. If their firm was over budget, was it because of an error in the planning process, or was it a onetime expense that the firm incurred and which is unlikely to repeat itself in the following year?
As their fiscal year comes to a close, firm leaders should take stock of their cash position, any investments, the value of their case/matter inventory, any liabilities and the terms of those liabilities, and the overall quality of their balance sheet. These indicators will give them a glimpse of the financial footing they’re on, whether their inventory is strong or in desperate need of new matters, and what liabilities their firm might need to pay before it distributes profits to equity partners and pays bonuses to attorneys and staff.
Gaining a comprehensive understanding of current-year performance is a crucial first step for firm leaders before starting their financial planning for the following year.
Pillar #2 – Projecting the Next Year’s Revenue
In a previous article, we argued that leaders of law firms, especially contingency law firms, could manage their law firms with one equation:
Prospects x Contact % x Qualified % x Retained % x Fee Generating %
x Average Fee – (Fixed + Variable Expenses) = Net Income
The first three-fourths of the equation (i.e., until the part concerning expenses) can predict what revenue a firm can generate based on new prospects, which is the foundation for projecting most firms’ revenues. Firm leaders can simplify the first three variables to “matters opened,” and should run this equation monthly based on new matters from new and current clients.
With the understanding learned from reviewing the current year’s financial reports and KPIs, firm leaders should have an understanding about what these metrics looked like in the current year and, thus, what they may look like in future years. Firm leaders should be able to determine whether their success rate signing clients will go up or down the next year, as well as whether their clients’ average fee will go up or down the next year. They can then use these new inputs to project future revenues.
The above formula does not account for time. At contingency law firms, time is the most challenging variable to predict because it is somewhat unknown how long each matter may take to litigate and resolve, especially when first opening the matter. However, firm leaders can, and should, leverage the historical data they have to get an idea of how their matters have progressed over time to estimate the time needed to resolve one favorably.
While it is still difficult, if not impossible, to predict the duration of a specific matter, one can assume and apply that, over a large enough inventory, similar matters will have a similar duration to those before them. The larger a firm’s historical data set, the more accurate this statement will be. Of course, firm leaders can add modifiers based on observed changes (e.g., matters are settling two months faster because of certain court calendaring changes) or other variables (e.g., a global pandemic is delaying jury trials by 18 months).
Regarding predicting time, firm leaders can create a distribution table to learn how many, and what percentage, of matters resolve and generate a fee within different increments of time. These increments of time should vary from practice to practice because a distribution table needs to have enough data during a time period to warrant it statistically significant. A high-volume practice that generates fees in 100 matters each month, will have more data points each month than a practice that generates fees in 100 matters each year. Thus, the former’s monthly projections could be reasonably accurate and valuable, while the latter’s projections might be most accurate and valuable if done on a quarterly or bi-annual basis.
Firm leaders should aspire to be able to say that x% of their matters generate fees within one month of the matter coming into the firm, y% generate fees within two months, z% generate fees within three months, etc. Firm leaders should also review outlier matters. What were the facts of a matter that generated fees in less than one month? What were the facts of a matter that took 60 months to generate fees?
Using the above equation, if a firm opens 100 matters, knows that 75% generate a fee and the average fee is $100,000, then the firm knows it will eventually generate $7.5 million. The firm would then use its distribution table to say that 10% of revenue is earned in the first six months, or $750,000, and 20% is earned during months six through twelve, or $1,500,000. Thus, the firm could then expect approximately $2,250,000 in revenue within the next 12 months if it opens 100 matters. Firms can, and should, use this equation to continue to project revenues years into the future.
In addition, firm leaders should identify those matters in their inventory that could change projected revenues. For plaintiffs’ firms, that could be a handful of potential eight-figure contingency matters that rely on novel theories of liability. For defense firms, that could be a new client whose standalone low six-figure project develops into an eight-figure, multi-jurisdiction, multi-practice group behemoth. Firm leaders should understand the chances that those increased revenues come in, what are the budgeted (or non-budgeted) expenses that those revenues could go toward, and continue to monitor the progress of those matters so it is not a surprise when one turns out to be a winner for the firm.
Firm leaders should create models for each practice area at their firm so that the models reflect the inherent differences between their practices regarding these metrics. It is likely that each practice area has its own unique facts, processes, and expected outcomes, and so each should be treated separately during financial planning. The sum of each practice then represents the firm’s total expected revenue.
In part II of this series, we will discuss the third and fourth pillars of law firm year-end financial planning: goal setting/budgeting and reporting.
If you have questions about the two pillars we discussed above, or year-end financial planning at your firm generally, please email us. We’d be happy to talk you through the process.
Shawn Lehocky is the chief executive officer of Pond Lehocky Giordano LLP, the largest workers’ compensation and disability law firm in Pennsylvania, and one of the largest in the U.S. Bryan Reilly is the firm’s chief financial officer. They can be reached at firstname.lastname@example.org and email@example.com, respectively.
Reprinted with permission from the December 5, 2023 edition of The Legal Intelligencer © 2023 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or firstname.lastname@example.org.