Financial Management: Getting close to the figures

With the emergence of the law-firm LLP and the post-Clementi world of ever-greater competition in the legal market, the financial management of firms is more important than ever. While many law firms spend a lot of time formulating their strategy, it is vital that they then back this up with changes to financial measures to support it. The potential force for change in financial measurements can often be overlooked in the planning process. The result is that firms risk having so many measures that they lack clarity of purpose or ‘can’t see the wood for the trees’.

What gets measured gets done
Financial management is separate from financial reporting, and supports the objective of turning strategy into reality. Are your performance measures designed to encourage value-added activities? Do they link in with your firm’s strategy?
Perhaps you are weighed down by multiple measures. How did these arise? Often they are created for a specific need and have outlived their usefulness. Too many measures rob the firm of focus.

Adding value
The starting point is to understand what activities add value to the firm. It can be unhelpful to look to institutional investors for guidance on financial-management techniques – they have shifted to cash-based appraisal for quoted companies. They ask: ‘Does the activity tend to create cash, or consume it?’. Unlike public companies, for a law firm a strong balance sheet – more assets – is a bad sign, as it indicates cash and working capital is tied up rather than being available to distribute.
For law firms, the key measure of performance has recently been profit per equity partner (PEP). If increased PEP is the strategy for the firm, then measures that promote this should be key. Contribution to PEP and accompanying measurements are usually enshrined in the annual budget.
In a legal environment, budgets are often used as the basis for partner distributions, with a ‘bonus’ distribution (profit share) for beating budget. As a result, budgets are nearly always set conservatively. This doesn’t reconcile well with setting and achieving demanding goals. Closer financial management suggests that forecasting should be used in addition to the budget to give management a realistic view of likely results for the period(s) ahead. This allows corrective/reinforcing action to be taken well in advance.
Alignment of rewards and objectives does not only depend on setting valid targets: it means accurate measurement of performance against target. The graph in table one sets out graphically how a stretch target might be met through a combination of value-added and value-destroying activities.

Keep it simple
Do you struggle with complexity? Because if information can be produced, it often is. The resulting build-up of historical reports can be paralysing. An ideal set of measures we have found is around 60, with far fewer than this being viewed by the executive.
The key is to have measures that support decision making. Value is created or destroyed at the point where decisions are made: what information is provided to the decision maker to help them make the right choice?
For example, do your measures support doing profitable client work? You should be able to determine which clients and fee earners are generating the most profit, after taking account of ‘hidden’ extra costs like bill preparation, marketing efforts and free training. Profit should not be the only target for your firm; you would be better served by having targets for each key driver of profit.
Similarly, include non-financial measures at the appropriate level:

Staff – staff growth, staff turnover, staff satisfaction;
Skills – development, training;
Delivery – client satisfaction, margin and margin percentage, proportion of large clients;
Selling – percentage sales to key clients, revenue growth;
Clients – satisfaction.

These need to be linked to the financial-management measures to deliver a whole picture of what has been and what will be happening at the firm.
I would suggested the following route to overhauling your reporting:

Strategy. Decide what financial measures support what the firm is aiming to achieve;
Benchmark. Look at what other firms in the sector are achieving, decide what the key measures are and what the target value should be for them;
Set targets. This enables the firm to promote the measures that indicate whether the firm’s strategy is being met;
Brainstorm improvement opportunities, from strategic through tactical to operational. While it is all well and good identifying the ‘top table’ reporting to measure whether the firm is attaining its’ strategic goals, it is also vital to identify the second and third ‘levels’ of reporting required to back up and help explain variances in the headline figures, as table two illustrates.

Starting from a firm objective of reaching a desired rate, a system of shared goals can be established with sub-divided objectives, so each area knows what is expected, and departures from that can be captured and analysed. The results of the analysis can be fed back so the original measure can be refined. The top-level measures can be characterised as strategic. After external benchmarking, the leadership needs to determine what rates the firm should expect to achieve. At the practice-specialism level the overall firm objective translates to a rate relevant to their marketplace. Analysis of the variance into client discount, write-off or staff mix would occur at this level.
Operationally, the individual decisions regarding all factors affecting rate are made at a matter level, and partners’ reports should show these elements on a regular basis:

Profitability. You need to be able to distinguish between clients who are profitable and those that are not;
Include predictive reporting. You should not only have historical accounting – that is like driving while looking through the rear-view mirror. Forward-looking measures are essential to navigating the route to success – revenue forecasting, based on headcount, utilisation, rates, WIP and write-offs, jointly owned by finance and the business;
Do you link rewards to financial performance? Explicitly rewarding staff for certain behaviours can be very effective. Obviously, partners share in the profits of the firm, but financial measures are key to determining how to link staff rewards to performance. Once again, you need to determine what behaviours you want to reward: should it be utilisation (promotes a key productivity driver, but can emphasise volume over quality), or the firm’s overall performance (‘share’ in the profit, but a remote measure for many staff)?
Financial management and risk. Knowing what value your firm has at risk, set against your firm’s attitude to risk will enable you to take the right decisions regarding the exposures you have. Using table three, you can quantify and then plot the different areas where your firm could be impacted.

Consider whether your systems support the above. You may need new performance-reporting systems. Are the finance, HR and marketing systems integrated, in order to seamlessly pick up the financial and non-financial measures you require?

So, is that it then?
Once you are measuring the firm closely there is, unfortunately, no chance to relax. Some measures will inevitably be encouraging the wrong attitude and will need to be modified. Recently, legislation has played a major role, and with increasing numbers of firms moving to LLP status, the importance of fees as a driver of revenue has declined.
If you get reporting right, you will be able to move from number crunching to being a valued business advisor.
Closer financial management does not mean more financial management. With increased focus and alignment of measures to the correct level of hierarchy, it means smarter working, not harder.

Tim Nash is head of financial control at Eversheds LLP. He can be contacted at timnash@eversheds.com