Growth can carry hidden threats

When, in 2013, firms like Blakemores, Challinors and Cobbetts found themselves in real financial difficulty, the regulatory spotlight began to shine on weaknesses in the financial management of law firms. Traditional accounting ratios deployed by banks and accountancy firms hadn’t forecast these collapses.

A stream of press articles reported that, as a result of its own survey amongst regulated firms, the Solicitors Regulation Authority considered 1,200 firms (over 10% of all law firms) to be at risk of imminent financial difficulty.

Since then, oil prices have slumped, unemployment rates have fallen, confidence levels have begun to climb, wage increases are outstripping inflation and UK GDP growth rates have reached close to 3% per annum… so is the worst well and truly behind us?

Yes, unless growth itself hides a financial threat.

Telltale signs of impending financial distress

While he was European head of restructurings at Citigroup, then the world’s largest bank, co-author of this piece Steve Din compiled a weekly list of European companies together with ‘lagging’ as well as ‘leading’ indicators of insolvency, so the bank could anticipate where financial difficulties were most likely to occur.

Lagging indicators flag after the corresponding cause, for example following the publication of a company’s latest accounts, while leading indicators show up immediately before an event, such as the loss of an important client. It’s no surprise that banks and regulators are interested most in leading indicators. They are seeking reliable indicators, even predictors, of future events.

Lagging indicators

But there’s a lot to learn from the study of even lagging indicators. Non-dormant LLPs and limited companies usually must file within nine months of their financial year-end, at a minimum, an abbreviated balance sheet with Companies House. These can be downloaded by anyone with £1 to spend.

An abbreviated balance sheet contains very limited financial information. It is, by definition, historic and therefore out-of-date. Nonetheless, it still tells us how much or how little working capital a law firm had at the time its balance sheet was signed.

As many lawyers will know (and if you don’t, it’s never too soon to find out!), working capital is calculated by deducting current liabilities (such as amounts owing to creditors, including HM Revenue & Customs, and any short-term borrowings) from current assets (such as amounts owed by clients and cash-at-bank).

Negative working capital means current liabilities exceed current assets – considered by GCSE and A-level business studies textbooks as a recipe for financial catastrophe. The problem is compounded for law firms because significant levels of working capital are often tied up in receivables and other work-in-progress that simply cannot be quickly converted into that essential commodity, cash.

We recently downloaded from ExperianIQ the last five years’ published balance-sheet data for 6,500 incorporated law firms and grouped them, by net asset value, into deciles. The smallest 10% of firms are in the 1^st decile, the largest 10% in the 10^th decile.

The first, rather worrying, observation was that 29% of all firms reported in their most recently filed accounts that they had negative working capital. The second observation we made was that the earnings, cash and receivables levels of the very largest firms (those falling in the 10^th decile) represented a multiple of those in all the lower deciles, thus reaffirming a commonly held suspicion that the largest firms tend to the strongest financially.

However, the backbone of the legal sector is represented by the firms in the middle 80%. We examined more closely how working capital broke down into cash and receivables for the 80% of law firms that fall into the 2^nd to 9^th deciles. Firms falling into the 8^th and 9^th deciles appear to be generating a significant level of earnings so, at least just before payments are made to partners and HMRC, the firm should enjoy strong cash balances and positive working capital.

What is notable is the rate at which the receivables line moves away from the cash line. A disproportionate element of working capital amongst these larger firms remains tied up in receivables. In contrast, the smaller mid-sized firms, particularly those in the 5^th, 6^th and 7^th deciles, on average, reported end-of-year cash balances that exceeded their receivables balances.

For the 2,000 law firms that have filed balance sheets over at least the last four financial years, their average receivables balance climbed over this period by over £450,000, whilst their cash-at-bank increased over the same period, on average, by less than £25,000. Based on this analysis of just a few rudimentary lagging indicators amongst law firms’ balance sheets, working capital is increasingly being tied up by law firms in receivables rather than cash. This goes some way to explaining the solid rise in insolvencies and restructurings that occurred up until 2013.

So much for lagging indicators.

Leading indicators

Any compliance officer for finance and administration (COFA) wanting to analyse and assess, more reliably, their projected working-capital needs will need to take a more sophisticated approach, based more on the individual circumstance of their own firm.

If a law firm is proposing to merge, invest in capital expenditures, acquire a block of work-in-progress or another firm, there is likely to be an imminent impact on its working capital. Even if that’s not the case, even gradual changes to a firm’s cost base, lock-up days or revenues will still impact cash-at-bank.

If we consider a hypothetical example of ‘Downton Abbey Solicitors’, simple analysis using business software such as Sage WinForecast shows exactly how working capital and cash are affected by, for instance, a growth in sales or a reduction in the time clients take to pay their bills.

In this example, rising sales and, for that matter, rising profits could be sufficient to trigger insolvency, as would a fairly modest increase in the average time clients took to pay their bills. If sales do grow to the point where there is no longer any cash left to pay creditors, that is called overtrading. The risk of overtrading increases in an expanding economy and is, equally commonly, considered a leading indicator of insolvency.

In order for a COFA to undertake their role effectively, the SRA requires them to have involvement over the entire financial management of the firm. COFAs need to consider how factors, beyond their control but eminently foreseeable, such as top-line growth and other financial variables may affect their future cash and other working-capital needs. There are any number of software tools, accountants and other advisors available to assist a COFA in measuring a firm’s working-capital needs.

Early insight could provide them with time to respond to those needs. More challenging is deciding how to address them.

Future insolvencies

The sharp contraction in credit, precipitated by the collapse of Northern Rock, government bailouts of RBS and Lloyds Bank and the ensuing economic hiatus, appears to have eased. However, with the opportunity for top-line growth comes the somewhat counter-cyclical new threat of overtrading, for any law firm or other business expecting to benefit from a buoyant UK economy. The worst may not be behind us. It may be immediately in front of us.

As a footnote, the above-mentioned Citigroup-commissioned list of companies facing insolvency or restructuring proved to be of little interest to companies in financial peril but of immense value to their competitors and private equity firms looking for assets potentially available at distressed prices in the near future.

Overtrading and financial distress can then present firms with opportunities as well as challenges.

Martyn Jennings is the chief executive of Burcher Jennings and Steve Din is the director of Doorway Management