We’re not trying to be hyperbolic here: your firm’s financial statements are the most important indicators of your firm’s overall health and sustainability. Oddly, lots of lawyers barely understand them, hardly use them, and put off analyzing them for as long as humanly possible. That’s a mistake.
This page has a very specific focus: to introduce you to the “traditional” financial statements and how they relate to your law firm. This is not a deep-dive about how you can use those financial statements to evaluate other businesses or how to evaluate your clients’ financial statements in the context of providing legal services. It is also not about your firm’s other “key performance indicators”—financial or otherwise—that may use financial data. This is decidedly not a tactical post about how you can make strategic decisions about your business based on your financial statements, and it isn’t about how to “fix” any numbers on your financial statements that look out of whack. This is a page to help you better understand financial statements and how they can help you get a better picture of the bigger picture of your law firm. So let’s get started.
The Four Standard Financial Statements
There are four basic financial reports in a complete, standard set of financial statements. They are:
- Income Statement (or Profit & Loss Statement);
- Balance Sheet (or Statement of Financial Position);
- Statement of Cash Flows; and
- Statement of Retained Earnings.
Income Statement (or Profit & Loss Statement)
This is a big one. Your firm’s income statement (or Profit & Loss Statement or “P&L”) shows your firm’s total income minus your total expenses. The resulting number is your net income (or, the so-called “bottom line”).
Think of a ladder. You start at the top rung with the total amount of sales your law firm made and collected during the period. Then you head down, one rung at a time. At each step, you deduct some costs and expenses that you incurred so that you could earn and collect the revenue (for example, the costs of services sold; operating expenses; and interest, taxes, and extraordinary expenses). At the bottom, after you have deducted all your expenses on the rungs above, you learn how much your firm actually earned or lost during the period.
Unlike your balance sheet, totals from your income statement do not carry over from year to year.
The key with your income statement is that you need to break categories into meaningful parent accounts and sub-accounts. If you only use parent categories (staff costs, for example), you probably aren’t seeing enough data to make useful decisions about staff costs. If you use a massive list of sub-accounts, on the other hand, the data you see may be too granular for useful analysis.
With your accountant or bookkeeper, think through how you can organize similar expenses in broad, understandable, and useful categories. You want meaningful detail, so think about the different ways that you spend money to earn (and collect) money in exchange for your legal work.
There are no right or wrong answers for expense categories. An income statement is just a tool you will use to make better decisions about how to manage your law firm. The income statement also lacks some utility by design. For example, it does not reflect owner draws, client advances, or line of credit payments. You’ll want to know those things, so you’ll need to look elsewhere.
The Balance Sheet (or Statement of Financial Position)
Your balance sheet displays the “balance” of your firm’s assets and liabilities and all the owners’ equity in the business. It is usually organized in one of two ways: 1) with your liabilities on the left and your assets and equity on the right; or 2) your assets at the top, followed by your liabilities, then your shareholder equity.
As the name implies, your balance sheet will…balance. So your assets minus your liabilities will equal the sum of all owner equity. The totals carry over into the next reporting period, so you sometimes see a balance sheet that compares the current reporting date with one or more historical ones.
A balance sheet is definitely a useful document. It has its limitations, though. First, your firm’s balance sheet is merely a snapshot of a particular moment in time.
Second, because most small and solo law firms maintain their books on a cash basis, their biggest accounts at a particular moment in time shouldn’t be reflected on the balance sheet. So your balance sheet doesn’t show your accounts receivable or your unbilled work, and it doesn’t reflect accounts payable or other liabilities, either. You need to know those to understand your firm’s true financial position at any given moment.
Lastly, a balance sheet doesn’t usually reflect your intangible assets like trademarks, systems and procedures, and goodwill (unless you’ve actually had a valuation on these things done). And because we believe meaningful portions of your firm’s value can rest in your intellectual property and goodwill, that is a limiting feature of your balance sheet when viewed on its own.
If you compare this year’s current assets minus your current liabilities with last year’s, you can see the trajectory of your firm’s annual growth and expenses. Your fixed assets minus your fixed liabilities, on the other hand, gives a picture of your firm’s value over time as it pays back debt and invests in fixed assets like technology and supplies.
Statement of Cash Flows
Cash, they say, is king. Your statement of cash flows (or “cash flow statement,” if you prefer) tells you where your cash comes from and where it goes, and it groups those inflows and outflows into useful line items. Some people refer to this as your firm’s “sources and uses” for a particular time period (traditionally, one month). It gives you short-term outlook you can use on a daily basis to manage paying bills, handling unexpected equipment repairs or replacements, and funding payroll. Unlike your income statement, your cash flow statement does not include non-cash accounting items like depreciation and amortization. It shows your short-term viability and how likely it is that you will be able to pay your bills and vendors.
Statement of Retained Earnings (or Statement of Changes in Owners’ Equity)A healthy law firm generates healthy cash flow from its core business activities. At its heart, this report helps you understand if you’re generating a cash surplus from your operating activities, your investing activities, and your financing activities. You should be creating a cash surplus from those things. If you aren’t, the cash flow statement can help you understand why. Do you have a long-term, foundational problem? Or is it a short-term deficit that resulted from your investment in things that will make you money in the future (new software, equipment, or marketing, for example)? Are you expecting to sustain long-term cash flow from operations, or are your numbers goosed by infusions of funds from credit?
Owners’ equity is the sum of the owners’ initial investments when they launched the firm, plus any “retained earnings” they have reinvested since then.
So your firm’s Statement of Retained Earnings shows how the owners’ equity has changed in a given period. Changes might show on this report if you sold or repurchased stock or membership interests, issued dividend payments, draws, or other distributions to owners, or if your profits and losses ended up impacting owners’ equity.
Some Miscellaneous Reports
Trial balance. A “trial balance” combines your balance sheet and income statement into one report. Its purpose is to detail the total of all debits and all credits in every account on your general ledger to show any discrepancies. If the sum of all your debits doesn’t equal the sum of all credits, there is an error somewhere.
Budget v. actual. A report that compares amounts you budgeted with your actual income and expenses in a given period. A third column (the delta or % of budget column) tells you how close you came in real dollars or as a percentage of the budget.
Weekly financial status report. We’d like you to look at a snapshot of your firm’s financial situation at weekly intervals to help you stay on top of your firm’s finances. One way to do that is with a weekly report that gives high-level views of cash on hand, accounts receivable total (and current, 30-60, 60-90, and 90+ A/R), payables due next Friday, payables due in the next 30 days, work in progress (from last month’s billing cutoff), bills sent (month to date), cash in (month to date), next payroll date and approximate amount, balance on the line of credit, etc. You can pick your categories, of course, but keep an eye on the critical numbers and distill out the less important things for this quick-look report.
Revenue per employee. If you have employees, this number shows your gross income divided by FTE (“full-time equivalent.” One FTE = one employee working full time, or about 40 hours/wk). You’ll need to find the number that you’re most comfortable with and the number that raises red flags for you. 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 (all of which, in turn, free you up to do high-revenue work more of the time).
Revenue per attorney (or timekeeper). This number derives from your gross revenue divided by the number of attorneys (or timekeepers). A brand new firm may have lower revenue as it establishes itself. But more-established firms with a low revenue-per-attorney number indicates that firm has attorneys doing low-revenue work, which, spoiler alert, ain’t good.
And on and on and on. There is a report for everything. Pick ones that are useful for your practice and figure out how to get the report populated quickly, easily, and systematically (or automatically, where possible).