Time for a Profitability Tune-Up
Law practices, like automobiles, require regular maintenance checkups to perform at their best. Think of all the moving parts that determine your practice’s profitability, from billing rates to overhead to your collections headaches. If your car has a set maintenance schedule, why should your law firm be any different? As the end of the first quarter of 2012 approaches, now is a good time to check “under the law firm hood” and make sure everything is in optimal working order.
Regularly Review and Monitor Key Performance Numbers
Don’t wait for warning lights to appear on your dashboard. If you roll up your sleeves and check the basic moving parts monthly or quarterly, you’ll be on top of any signs of problems instead of scrambling to fix them after the fact. Here are a few numbers that are particularly important to monitor under the “new normal” of today’s law firm economics.
- Billing rates. Whether you use hourly, blended (average or effective), fixed fees or other alternative fee arrangements, it is important to understand their effectiveness and the economics behind them. For example, when are you able to bill premium rates? How do your rates compare to your competitors? Too often, lawyers arbitrarily assign billing rates simply because “they sound right” and the client accepts them. A billing rate should be covering your costs and be cushioned with targeted profit. Run the numbers and make sure the economics support your billing rates and other fee arrangements. Review benchmark surveys for billing rates among your competitors, too. Look at billing rates for similar-sized firms, practice areas and geographic area to see how you compare.
- Realization. Realization is the amount of time actually billed and collected. This is critical, so you’ll want to monitor both billing realization and cash realization very closely. Billing realization is the percentage of time billed to time recorded, while cash realization is the percentage of cash collected to time billed. On average, most realization should be in the 90 to 95 percent range or better. Assuming an hourly practice, when evaluating billing realization of standard rates, the general guideline to consider is whether your realization exceeds 97 percent or more on a regular basis. If it does, your standard rates may be too low. Conversely, if your billing realization is below 82 percent, your standard rates could be too high. These are simply benchmarks, but they can help you gauge the effectiveness of your billing rates. The simple translation is that it comes down to write-downs and write-offs of time. If billing realization is low, then too much time is being written off. This will have a significant impact on not only your billings, but your collection potential. If cash realization is averaging 100 percent, your firm is collecting what it is billing each month. However, if accounts receivable could be an issue, you’ll want cash realization rates in excess of 100 percent. Again, these are simply performance guidelines to consider when evaluating your billing and collection realization trends. Regardless of which guidelines you follow, collections should always be the first priority.
- Cash flow. This is the amount of cash collected to meet your cash requirements for covering operations. If your firm isn’t able to meet its financial obligations in a timely way, collections are probably an issue. Stay on top of your accounts receivable and move quickly to collect all overdue amounts. Have a collections plan in place ahead of time. The longer the accounts age, the less likely they are to be paid.
- Leverage. Under the new normal, leverage has become more popular than ever. For law firms, leverage is defined as the ratio of non-partners (associates/of counsel/paralegals) to partners. You achieve proper leveraging through improved project and task management, which in turn can improve revenues and profitability. Again, understanding the economics of your firm and timekeepers will give you the knowledge to properly assign legal work and maximize performance, revenues and profits.
- Operating expenses. Of course, monitoring your expenses is important and many firms work to reduce their expenses. But at some point the exercise becomes futile. Unless you plan to significantly reduce personnel, most expense cuts in operations don’t yield much of a material impact on a firm’s bottom line. Most firms right now are in a revenue-building mode—the “top line” is where your focus should be.
If you take the time to regularly perform some simple under-the-hood maintenance, you will hold the profitability line through 2012 and keep your firm purring sweetly along the road to success!
Frederick J. Esposito, Jr. is Chief Financial Officer for Rivkin Radler. He has more than 20 years of law and accounting firm experience. He writes and speaks extensively on legal management topics, including billing, collections, financial and profitability models, risk management, human resource development, project management and alternative fee arrangements. Follow him @lawmgtguru.
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