Cashing in: better money management

Firms must effectively manage their cash and react swiftly to a changing market to survive lean times.

The credit crunch and dwindling activity in the property market are dealing a double blow to law firms. As a partner in a legal specialist accountancy practice, I can tell you we are taking an increasing number of enquiries from firms with concerns over their cash positions.

All too often, the underlying problems are not just a consequence of the credit crunch or the property downturn – these factors simply act as catalysts for fundamental cash-management problems.

The downturn is emphasising the shortcomings of law firms: lack of cashflow planning; lack of understanding of what financial capital is needed to run the business; absence of a capital model to monitor the effect of changes in the business; and a reactive rather than proactive approach to financial management.

Statistically, most law firms in the UK are small, with fewer than ten partners. Their income sources come mainly from property, probate and matrimonial work. In terms of financial management and control systems, however, these firms impose the most constraints on their resources.

I would like to look at some of the key issues and controls that smaller firms – those with 50 or fewer partners – need to consider in the current economic climate to manage their cash position.

Smaller firms often find negotiating with banks for funding more difficult than their larger counterparts as they are perceived to have less stability and influence. Banks are only prepared to offer them more working capital funding provided they have additional security. While the first port of call by lenders for security is often property in the business, personal guarantees or second charges over personal property came a close second.

We have seen increases in personal security given by partners who are attempting to extend borrowing positions. This is not necessarily wrong, but it should not be seen as the easy answer to secure funding for a few more months. Unless partners are convinced that the money is being used in a sustainable business, they could be merely extending losses, while exposing previously unencumbered personal assets.

Monitoring activity levels
Key performance indicators (KPIs) should act as an early-warning system so that firms can take action to avert cash problems. For smaller firms, however, the recording and monitoring systems which are needed to obtain this information are either not in place, or the results are misunderstood.

Regular review of the following KPIs should give early indicators of where surplus fee-earner capacity exists and where staff redundancies are required:

• New matter start numbers, by type of matter and fee-earner;
• Earned income – fees issued, plus unbilled time movements, as opposed to issued fees alone;
• Percentage time charged by department and fee-earner; and
• Recovery rates (time charged compared with time written off) on billing.

The first two KPIs listed are critical indicators of activity levels. Many firms will often say activity levels are ‘holding up’ because they are completing matters that started six months ago and that unbilled time (work in progress and accrued income) is just being eroded.

Following FRS 5, most firms are familiar with seeing their year-end reported profit shares swelled by the growth of unbilled time. Over the next few years, firms will probably experience the reverse effect in their end-of-year accounts as activity levels decline. It is important that firms consider the effect of this movement in unbilled time in their internal financial results to avoid nasty shocks in their end-of-year accounts.

Speed of response
We often see that financially stable firms can quickly lose this position by not responding to the market. By responding, I mean either taking early action to reduce employee numbers in underperforming departments and diverting resources to new advice areas, or holding back on development.

Every additional month an employee is retained while a decision is being made about the future erodes the cash position from which the firm can start to build income from another source.

Making decisions swiftly with accurate information is a key way to preserve the financial position of the whole firm and safeguard the jobs of a larger number of people.

Information for funding providers
Funders need to feel confident that propositions are robust. An effective way to do this is to provide them with meaningful financial information. For most firms, this should be easy to achieve: accounting systems usually provide instant profit-and-loss accounts and balance sheets, together with information about activity levels.

Providing funders with monthly information, together with commentary on the fluctuations in key figures, offers a great source of comfort. It is critical, though, that this includes a cash-flow forecast, which most firms are still not using as a management tool.

If a firm’s early-warning KPIs are telling it that additional finance will be required, alerting the bankers to the issue with some financial information a few months early will show that the firm is in financial control of its business and is proactively managing it. This would be much better than a message conveyed by a telephone call the day before the VAT bill needs to be paid, requesting an extended overdraft.

Cash restrictions mean that it is important for firms to save for large tax payments falling due. The discipline of establishing separate savings accounts for key tax payments enables firms to understand the extent to which they will need to use their overdraft facilities.

Operating set-off arrangements between bank accounts lets firms reserve on a monthly basis for these known liabilities. This also then gives a balance on the main current account, which is after known liabilities, ensuring the business is making decisions based on the real cash position.

Many firms do not actively control the level of capital they hold in their businesses. The balance held on partner capital accounts will simply be the product of profits to date that have not been drawn.

All firms need to regularly review the level of capital they require and have an agreed policy to determine how this capital is funded. Capital needs will be dictated by factors including types of work the firm undertakes, existence of partnership property, management of lockup, as well as investment in fixed assets such as IT infrastructure.

Once the level of capital required is established, firms can then decide how much capital is funded by external providers such as the bank, and how much is funded by partners.

These processes provide a point of reference to firms to control changes in their business, such as the development or demise of an income stream. Without this information, it becomes difficult for firms to understand what drives the cash requirement in their businesses.

New income streams
The property downturn, together with the need to address the expected consequences of the Legal Services Act, mean many firms are looking to develop new income streams.

This may create new and additional funding requirements. If the cash position is already stretched, the impact of funding new work on cash needs to be assessed in advance.

In these circumstances, an expensive area to develop in terms of cash would be litigation work, particularly no win, no fee-type arrangements. Conversely, in a downturn this is exactly the type of work that receives a boost and is attractive to firms.

The real cash cost of funding such work includes not only up-front fee- earner salaries that can run into years but also disbursement funding and a proportion of the firm’s overheads which enables such cases to be run.

While new income streams appear to provide a golden opportunity, firms need to ensure that they can actually fund work before they embark on new projects. Approaching finance providers early to be assured of their support is a key consideration.

For larger firms with credit departments this may seem a basic point, but we need to be mindful that the majority of firms in the UK do not have such a resource. Credit control is often handled by the in-house cashier or a finance-orientated partner when the bank balance gets too low.

As we move into less certain economic times, firms need to ensure that they apply simple credit procedures including:

• Setting and reviewing compliance with credit limits for new and existing clients;
• Obtaining payments on account to fund disbursements and early stage work; and
• Credit checks for new significant clients to ascertain credit worthiness.

In times of budget pressure, fee-earners will grab opportunities for work. While a firm does not want to curtail this enthusiasm, having safeguards will help it avoid the risk of picking up loss-making work.

Controlling lock-up
For many firms, the most problematic area of cash management arises from unbilled time and fee/disbursement debtor funding. This represents the cost of fee-earner time taken from when a fee-earner starts work on a matter to when the cash is ultimately collected from the client (lock-up).

In general, finance providers are able to provide less funding for these assets and the cost is higher as a result of lower-quality security.

Any actions that can be taken to minimise lock-up will provide the cheapest form of cash available and can safeguard against bad debt. Some of the procedures which will help reduce the level of capital absorbed by this asset are:

• Set a billing day in the middle of each month where staff, especially partners, do nothing but issue fees;
• Daily transfers from client to office account for fee settlement;
• Increased levels of fixed payments on account from clients; and
• Discounts for early settlement.

Following the advice which is relevant to your firm should help you navigate troubled waters, at least in terms of your cash management.

Andrew Allen is legal sector partner at Winter Rule Chartered Accountants in Cornwall and a committee member of the Institute of Chartered Accountants in England and Wales Solicitors Special Interest Group

Taxing times

Many legal partnerships operate accounting year-ends of 30 April, 31 May or 30 June – that is, shortly after the end of the tax year on 5 April. In a rising profits market, this gives the cash advantage of a delay of up to 21 months before income tax on rising profits is paid. This has provided many firms with a favourable cash position, particularly over the last few years.

For many of these firms, in the current climate this means income tax payments on the strong profits of 2006/2007 will not be fully settled until 31 January 2009.

Therefore, it becomes essential that these firms reserve cash now to pay future tax, so that the cash collected from the strong profit years are not either absorbed in new projects (for example, funding new income streams) or lost in unprofitable trading times.

By contrast, firms with an accounting year-end towards the end of the tax year, for example 31 March 2007 or 5 April 2007, the income tax on the last strong profits year will have all been paid by 31 January 2008.

For these firms, attention should be given to the payments on account due in July 2008 for the accounting profits year ended in 2008. If the 2008 accounts are showing a significant reduction on the 2007 results, then reductions to payments on account in January 2008 and those due in July 2008 can be made to preserve cash.

Payments on account for firms with years ending after 5 April 2008 (for example, 30 April 2008) are also relevant but will not create any effect until 31 January 2009, when the first income tax payment on account is made in respect of this accounting year.

Overall, careful management of income tax payments can in themselves provide a significant source to ease cashflow in certain cases.