Reading a financial statement often feels like trying to see the hidden picture inside an optical illusion (or, maybe like trying to find Waldo), squinting your eyes so hard you get a headache. There are numbers, symbols, decimals…the list goes on. It’s easy to toss it to the side out of frustration, telling yourself you’ll try better next time. After all, your firm’s lights are still on—what could go wrong?
This is a mistake. Although you may be keeping your lights on, you could be missing some financial red flags that could damage your firm if ignored.
Your law firm financial statements are the most important indicators of your firm’s overall health and sustainability. Although you may find them difficult to understand at first, they’re critical for growing your business.
Thankfully, these statements are simple to dissect once you know the basics. We’ll show you how to properly read and understand the core law firm financial statements you should use within your firm.
The Four Standard Law Firm Financial Statements
To understand the financial health of your firm, you need to pay close attention to four basic financial reports inside the standard set of law financial statements. These reports include:
- Income Statement or Profit & Loss Statement
- Balance Sheet or Statement of Financial Position
- Statement of Cash Flows
- Statement of Retained Earnings
Key Terms to Know
We know we’re already throwing the jargon at you. That’s why, before we go further into what each of these law financial statements includes, we’re going to define the key terms you need to know first. For brownie points, feel free to save these definitions to your device for future use.
- Accounts payable: Your accounts payable is a ledger of amounts under your current liabilities that you owe to a supplier or another company. For example, your internet bill is part of your accounts payable.
- Accounts receivable: Your accounts receivable is the amount your debtors (i.e. clients) owe you. For example, open invoices that clients owe you are part of your accounts receivable.
- Assets: An asset is any tangible or intangible item of value that your business owns. For example, tangible assets include vehicles while intangible items include intellectual property.
- Cash flow: Your cash flow is the net amount of cash that you transfer in and out of your law firm, including the cash gained in sales and lost through expenses.
- Expenses: Your business expenses include the costs of running your business such as internet, phone, software fees, electricity, etc.
- Income: Your income is the overall amount of money you take in as a result of serving your clients.
- Liabilities: Liabilities include your accounts payable, mortgages, accrued expenses, etc. They are the financial debts or obligations you need to run your firm.
- Loss: When you have more expenses than you do earnings, this results in a loss for your firm.
- Net income: Your gross income minus all expenses and costs results in your net income.
- Profit: Your profit is the revenue you generate in your business that exceeds your costs and expenses.
- Retained earnings: Your profit can be distributed to the owners/shareholders as dividends or re-invested back into the company to fund future growth. The money not distributed in dividends is called the retained earnings.
- Revenue: Revenue is the income you gain from conducting business within your firm.
- Shareholder equity: If you pay all of your law firm’s debts, shareholder equity is what would be leftover. It equals your assets minus your total liabilities and represents the financial health of your business.
- Trial balance: A trial balance is a report you typically compile at the end of each quarter that lists the balances inside your general ledger. It’s a tool you can use to ensure that the entries balance.
Whew. Still with us? Good. Now, let’s discuss each of the four basic law firm financial statements you need to use in detail.
The Income Statement (Profit & Loss Statement)
Let’s start with one of the most important statements you should collect on a regular basis: your income statement, also known as your profit and loss statement or P&L. This statement shows your firm’s total income minus your total expenses, resulting in your net income or bottom line.
Total Income – Total Expenses = Net Income
Take a moment to consider a ladder. You start at the top rung with the total amount of sales your law firm collected during a given period. As you head down, at each step, you deduct costs and expenses incurred to earn and collect revenue (costs of services sold, operating expenses, taxes, etc.).
At the bottom of the ladder, you deduct all of your expenses on the rungs above and you learn how much your firm actually earned or lost during that given period. These totals don’t carry over from year to year.
Parent Accounts & Sub-Accounts
The key to making your income statement helpful is breaking it into categories: parent accounts and sub-accounts. For example, only using parent categories such as payroll won’t allow you to see enough data to make useful decisions about staff costs.
On the other hand, if you have too many sub-accounts, the data may be too small to be useful. With the help of your accountant or bookkeeper, consider how you can organize similar expenses into broad, understandable, and useful categories. There are no right or wrong answers. After all, this is a tool you’ll use to make better business decisions for your firm.
The Balance Sheet (Statement of Financial Position)
The next critical financial statement you should have is the balance sheet, also known as the statement of financial position. This statement displays the balance of your firm’s assets and liabilities with all the owners’ equity in your firm. Typically, you organize this statement in one of two ways:
- Liabilities on the left and assets-plus-equity on the right
- Assets at the top followed by liabilities and then by shareholder equity
As the name implies, your balance sheet should indeed balance. Take a gander at this simple equation:
Assets – Liabilities = Owners’ Equity
The totals carry over into your next reporting period. You may see a balance sheet that compares the current reporting date with one or more historical ones.
Why Do You Need a Balance Sheet?
This is a great question that has a simple answer. By comparing this year’s current assets minus liabilities with last year’s you can see the trajectory of your firm’s annual growth and expenses. It should be your goal to continue growing your firm. Your balance sheet will define whether you’re successful and help you determine what you can do to reach your goals.
When you group together balance sheets for several periods, the result is as if you have your own crystal ball, showing your firm’s financial trends. You can use your balance sheet to:
- Compare your amount of debt to your equity to view your level of borrowing
- Compare assets to liabilities to see if you have the funds to pay off those debts
- Discover if your financial resources require an increase to keep up with normal business activities
- Track your current cash flow to see if you’ll have the necessary funds to pay your bills, yourself, and your team
As you can see, a balance sheet is incredibly useful for your firm. But there are limitations to the statement when you use it on its own. For example, your firm’s balance sheet is only a snapshot of a particular moment. Plus, most small and solo law firms maintain their books on a cash basis. This means you should not include the biggest accounts at one particular moment in time on the balance sheet.
As a result, the balance sheet won’t showcase your accounts receivable or your unbilled work. This statement will also lack your intangible assets such as trademarks, systems and procedures, and goodwill, all meaningful portions of your firm’s value. You need to know all of these things to understand your firm’s true financial position at any given moment.
Statement of Cash Flows
Your business needs cash to operate. As the owner, you need to know if you have enough cash in the bank to fund operations each month. Cash flow issues pop up for all types of businesses no matter what the size–one bad collections month or an unexpected bill can significantly impact your cash position. Staying on top of your cash position can help you avoid unexpected dips or manage them when they come.
Your statement of cash flows (or cash flow statement) shows you where your cash comes from and where it goes in a month’s time. It gives you a short-term outlook you can use on a daily basis to manage your bills, unexpected equipment repairs after accidental coffee mug explosions, funding payroll, and so much more.
Your cash flow statement should only showcase your short-term viability, which means it doesn’t include your non-cash accounting items such as depreciation or amortization. Instead, you can use your cash flow statement to understand why you’re not generating a cash surplus from your business activities. For example, a cash flow statement can help you determine:
- If you have a long-term, foundational issue
- If you have a short-term deficit resulting from an investment that will make you more money in the future
- If you’re able to sustain long-term cash flow or if your numbers are off due to funds from credit
Statement of Retained Earnings (Statement of Changes in Owners’ Equity)
Finally, we’ve reached the fourth critical financial statement for your firm. Your statement of retained earnings is used to show how owners’ equity has changed in a given period of time.
Your retained earnings are what’s leftover after you distribute the dividends from your law firm’s income. Your owners’ equity is the sum of the owners’ initial investment when you launched your firm, plus any retained earnings they have invested since then.
As an example, you might reflect sold or repurchased stock or membership interests on this statement. You could also include issued dividend payments, draws, or other distributions to owners. Also, you can reflect if your profits and losses end up impacting owners’ equity.
This statement is especially important for stakeholders within your firm, as it showcases how much equity they hold in your business. Plus, it shows how much available owners’ equity you have to reinvest back into your firm in the form of expansion, new equipment, or debt payoff. Armed with this statement, you and your partners can decide the best way to move forward.
Other Miscellaneous Financial Reports
Now you have the info you need to prepare the four critical financial statements you need to run your firm. There are additional financial reports you can use for even more insight into your financial health.
- Trial balance: This statement combines your balance sheet and income statement into one report. Its purpose is to detail the total of your debits and credits in every account to show any discrepancies. If the sum of your debits and credits don’t equal, you’ll know there’s an error somewhere.
- Budget vs. actual: This report compares the amounts you budgeted with your actual income and expenses in a given period. A third column on the statement tells you how close you came in real dollars or as a percentage to your budget.
- Weekly financial status report: We recommend looking at your firm’s financial health weekly. The easiest way to do so is with a weekly report that includes a high-level view of cash on hand, accounts receivable total, payables due next Friday, payables due in the next 30 days, work in progress, bills sent, cash in, next payroll date, and balance on lines of credit.
- Revenue per employee: If you have employees, these numbers show your gross income divided by full-time equivalent (FTE), which equals one employee working full-time each week. Lower numbers hint at overstaffing, inefficiency, or underpriced services. Higher numbers suggest you charge consistent and fairly-priced fees, use robust systems and technology, and have low employee turnover.
- Revenue per attorney (or timekeeper): These numbers result from your gross revenue divided by the number of attorneys or timekeepers. A low revenue-per-attorney number indicates that your attorneys are doing low-revenue work, which, spoiler alert, isn’t good.
These statements are just the beginning. In fact, there’s a report for everything you can imagine. We recommend selecting statements beyond the top four that are useful for your firm.
You Can Master Your Law Firm’s Financial Statements
We know that, at first, financial statements read like a foreign language to many attorneys. You may feel like you’re drowning under what seems like thousands of statements, numbers, columns, and rows.
We’ve been where you are before. And we promise that understanding your law firm finances will keep your life, both in-office and outside of the office, less stressful in the long run. With practice and time, your financial statements will become some of your favorite aspects of managing your firm.
Remember: you can (and should) hire help if you need it, so you can better understand how to use these statements to your advantage. A bookkeeper or accountant can be a solid addition to your team.
Learn More About Financial Statements: Become a Lawyerist Insider
Maybe you have a grasp on your firm’s financial statements, but you want to learn even more. Good news — we go over this in our law firm survival guide, The Small Firm Roadmap. Click here to join Insider and download the first chapter.