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Chapter 1/6

Understanding Your Law Firm’s Financial Levers

Law Firm Finances

13 min read

Understanding the Basics of Firm Financials 

It’s time to get excited about numbers! 

That’s right! The days of lamenting that you don’t know or understand your numbers are over. To deliver amazing results for your company, employ your team, and make a living yourself, your business must be profitable. This means you must know, understand, and yes—even love—your numbers. 

Don’t panic. We’re going to roll up our sleeves and help you understand some financial basics to get you started. Then, we’ll dig into it so you can learn what levers to pull to affect these parts of your business. See! It’s fun!

To get started, let’s get on the same page about the business’s major financial concepts and key terms to know. Then, we’ll dig into the levers you have at your disposal to understand how they can impact your business. 

Income or Revenue

This is the money that your business receives—the cash clients pay you for your services. 

There are two main levers affecting income:

  1. Price. How much do you charge for your different services? There are lots of different pricing models you can use in your business. For many firms, we recommend offering a combination of several price points or pricing models so that you can serve different ?clients. For more help with pricing, check out Lawyerist’s Complete Guide to Law Firm Pricing.
  2. Volume. How many cases or client matters do you handle? Obviously, handling more cases will generate additional income.

For many businesses, the key is finding the sweet spot for both price and volume. Increase your price and you might see fewer clients. Offer your services for less, and you might see an increase in volume.

Costs of Services and Operating Expenses

This is the money your business spends to operate.

It’s helpful to think of your expenses in two large buckets:

  1. Costs of Sales. These are the expenses, or costs, directly related to delivering your services. For law firms, this could include filing fees, gas, or travel expenses. It might include wages you pay for a contractor to deliver services for a particular client or type of case.  An easy way to think of these costs is to ask yourself, “but for this case, would I be spending this money?”
  2. Operating Expenses. These are the expenses required for normal business operations, including rent, insurance, salaries, and marketing.

Here are the levers affecting expenses:

  • Decrease expenses. Spending less money on things means you’ll have more money for yourself?. It’s a great idea to keep a check on expenses and not spend unnecessarily. But, unless you’re spending a lot of money on big-ticket items, it can sometimes be difficult to get meaningful results on your overall law firm profitability just by cutting expenses.
  • Invest in your business. Another way to think about expenses is to frame the expense as an investment. Will purchasing new technology allow you to automate your services and deliver them faster, with less employee time? It could affect your law firm profitability in the short term but might be a worthwhile long-term investment. Too many lawyers cannot see the opportunities for investing in their business. Don’t be shortsighted.

Profits or Net Income

Take the money your firm collects, minus the expenses. The result is your profits. Besides total profits, it’s helpful to consider your gross profit margin and profit margin.

  • Profit margin. This is all of your firm’s revenue, minus expenses, expressed as a percentage. Successful businesses should generate a profit margin of 10% – 15%. Note: if you don’t pay partners a fair market wage, it gives an inflated profitability picture. We’ll talk more about this later.

  • Gross profit margin. This is the percentage of revenue that exceeds the cost of sales. It relates to how much money you have left after paying all of your expenses related to selling your services. If you don’t have enough gross profit, you don’t have enough money to pay your operating expenses; that’s a terrible deal.

Operating Cash and Capital

You know what they say—cash is king. You certainly can’t run a successful law firm without it. But when we talk about cash, we’re not envisioning a stuffed briefcase full of bills under your desk. Instead, you must have cash in its two basic forms: cash flow and capital.

  • Cash Flow. Cash flow is the net balance of cash moving into and out of your firm at a specific point in time. This is the money you’ll need to pay for your monthly expenses. A positive cash flow shows that a business has more money coming in than going out.

  • Capital. Capital is cash put to work to make you more money. It’s like the gas of your business. This is money you use to invest in future growth—larger purchases & investments. Examples of capital include stocks, bonds, funds held in deposit accounts, and more. You can also access debt capital via credit cards, bank loans and other forms of credit.

Ultimately, you want your business to have access to as much cash as possible.

To positively impact cash flow, you can:

  • Decrease your Accounts Receivable. Accounts Receivable (AR) is the money clients owe you for the work you have performed. We’ll talk about ways to lower your AR in Chapter 3.
  • Decrease Work In Progress (WIP). Work in Progress is the value of the time that you have worked but haven’t invoiced. The key is to turn WIP into cash by invoicing your client as soon as possible and collecting the amounts owed.
  • Increase Accounts Payable. . Accounts Payable are the bills you owe to vendors who provide goods and services to your business. You can impact your cash flow by taking a longer time to pay vendors (but only if it doesn’t negatively affect your relationship with them). Consider negotiating longer payment terms.

These forces work together to form your firm’s financial outlook. Your firm’s financial reports are the best way to see this information. These reports can also tell you additional valuable information about your business as well. 

Understanding Your Law Firm’s Financial Statements

Let’s look at some basic law firm financial statements and why they matter.

Income Statement (Profit & Loss Statement or P&L)

Another term for your income statement is 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 profits or bottom line).

Total Income – Total Expenses = Net Income

Your Income Statement will break down your income and expenses based on how you set up your chart of accounts. Your chart of accounts is an index of how you want to classify your income and expenses into parent accounts and sub-accounts. 

With the help of your accountant or bookkeeper, consider how you can organize your chart of accounts into broad, understandable, and useful categories. For example, if you are an estate planning attorney and offer four different offerings (basic will, complex will, basic trust, complex trust), you would want to set up four sub-accounts under income for each offering. This would allow you to track how much income you are receiving from each offering. The same concepts hold true for your expenses.   

The key to making your income statement helpful is to think through your chart of accounts so that you can track meaningful information. For example, only using parent categories such as payroll won’t allow you to see enough data to make useful decisions about staff costs. If you have too many sub-accounts, the data may be too small to be useful. 

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 balance sheet displays the balance of your firm’s assets, liabilities, and the owners’ equity in your firm.

More terms to define:

  • 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.

  • Liabilities: Liabilities include your accounts payable, mortgages, accrued expenses, etc. They are the financial debts or obligations you need to run 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.

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 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 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. To understand your firm’s true financial position?, you need to know these things.

Statement of Cash Flows

Your statement of cash flows (or cash flow statement) shows you where your cash comes from and where it goes in a month. 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 many businesses, no matter the size–one bad collection 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.  

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 because of funds from credit

Statement of Retained Earnings (Statement of Changes in Owners’ Equity)

Your retained earnings statement shows how owners’ equity has changed in a given period. You can distribute profit to the owners/shareholders as dividends or reinvest it back into the company to fund future growth. The money not distributed in dividends is called retained earnings. 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.

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 as expansion, new equipment, or debt payoff. Armed with this statement, you and your partners can decide the best way to move forward.

These statements are just the beginning. In fact, there’s a report for everything you can imagine. While at first financial statements read like a foreign language, you can master them in short order. You’ll quickly learn which reports will be most useful to you. 

You Started a Firm to Make Money

Now that we have the basic financial concepts down, there’s one more point worth hitting now before we dig into details. You need to make money. 

We know it sounds obvious, but so many lawyers come to us thinking that they are doing “okay” financially. We start reviewing their books and quickly discover they could earn more working retail. It’s okay and understandable to pay yourself in the beginning when things are getting started, but your business must be able to sustain you. If it can’t, then it may be worth finding a place to work that can (because there are plenty of firms aligned with your values and would be a great place to work. We know because we work with amazing firms every day that would love to bring on a smart, talented person like you!)

Your firm should be able to compensate you in two ways. We’ll explain.

Market Rate for the Work You Do.  First, it must pay you a market rate for the work you do in the business. Think about it this way: if you had to replace yourself today with someone off the street that you hired to do your work, what would you have to pay them? That amount is your market rate. For our financial strategy purposes, we’re going to call this amount an “expense” and add it to your expenses. 

(Note: we are not trying to give you legal or tax advice on how to pay yourself and whether it should be through W2 wages or draw or whatever. We simply want you to classify or bucket this money in this way to see if your firm is financially healthy). 

This concept holds true for anyone in your family that you employ as well. We know lots of spouses running firm operations, marketing, client intake, accounting, and being the chief bottle washer. You should pay them a market rate for the work they do as well. 

Return On Your Investment. Second, as a business owner, you should receive a reasonable return on your investment. This is the firm’s profit. Healthy businesses should aim to generate 10-15% of their income in profits.

Why does this matter? First, paying yourself (and your family) market rate wages is great for your morale. Something happens in our brain when we know we are making the six-figure salary we deserve. Second, we know lots of business owners who have paid themselves this way through their payroll company (again, not giving you tax advice). They found that there was psychological ammunition when you know you have a payroll to cover. Suddenly, the owner worked a little harder to close that deal or collect the invoice to “make payroll.” These same folks told us they were more likely to pay themselves regularly when they set it up with their payroll and there is benefit to that as well. 

Go Deeper: Podcast Episode #272

4 Keys to a Profitable Law Firm, with Greg Crabtree

Listen to Episode

Finally, knowing that your business can pay your team (including yourself and your family members) their market rate gives you a clearer picture of your firm’s financial health. It means that you can cover all your expenses. Further, the “profit” you show at the end of the year really is profit. You’ll have a better understanding of your profit margin. Many lawyers brag that they have high profitability because they conflate these two concepts. These lawyers don’t see the true health of their business and are likely not making as much as they should. 

With these concepts in mind, let’s start building your financial strategy