Do you measure what matters?

As the credit crunch bites, Peter Scott outlines the importance of financial measurement and reporting, and maintaining profitability and generating stronger cash flow.

The effects of the credit crunch, and the problems in the financial markets, are highlighting issues for law firms, which, although present in the past, are now being exacerbated to a degree not experienced by some since the economic downturn in the early 1990s.

Many law firms are being forced to take tough decisions regarding those parts of their practices hit hard by the credit crunch, and redundancies are being made. Counter-cyclical practices within firms, however, such as corporate recovery, mortgage repossession and debt recovery, are beginning to take off – although growth can create its own problems for firms.

In an economic climate where trading conditions can change rapidly, law firms need to be able to closely monitor the impact external forces are having and are likely to have on their businesses. If decisions need to be made regarding the future of a firm – whether relating to growth or cutting back – then those decisions should be based upon accurate information and not on unreliable assumptions or guesswork.

A managing partner was recently reported to have commented: “Our strategy is to keep a lid on expenditure and weather the storm”. For many firms, those words will closely reflect their own priorities, which, at a time of falling profits and tighter cash, will be to seek ways to generate more revenue and accelerate cash collection.

This will require them to analyse, measure and evaluate every part of their business to identify the relative profitability of partners, groups, offices, sectors and work types to see where there is potential for generating more revenue from available work and available people resources. Overheads will need to be examined more closely than they were in the good times and fee-earner salaries will be frozen (as is currently happening).

Firms being forced to run leaner operations may be a positive consequence of these more difficult economic times. At the same time, log-jams in the way of accelerating cash flow will need to be identified and cleared.

Financial metrics aimed at identifying the causes of low profitability and poor cash flow in a firm will reveal more about overall performance, attitudes and behaviour than financial performance alone. Underperformance and behaviour issues will be highlighted in relation to client and internal relationships, supervision and delegation of work, the building of teams and other attitude problem areas. All of these can have an adverse impact on financial results, and these issues will need to be faced up to and dealt with if a firm is to succeed in achieving its objectives.

Maintaining profitability and accelerating cash flow are central to the current thinking of many firms. Some of the many questions firms are urgently asking themselves are:

Do we know how much profit/loss each partner/part of our firm is making?
Will this part of our firm/partner ever be capable of being profitable?
How profitable/loss making are each of our clients?
How can we see whether we are on budget?
Do we know what every item of overhead costs us?
Which parts of our firm are generating good cash flow/soaking up cash?
How much working capital do we really need in our firm?
Will we able to make distributions to partners from last year’s profits?
Will we be able to pay next January’s tax bill?
Will a cash call on partners be required shortly?
Are we able to measure what we need to know? If not, how should we go about it?

This final question is fundamental. It is where finance directors have a vital role to play, even though ownership of the process may need to be shared with several others, including the managing partner and those involved with business development and IT. Further questions may need to be asked such as:

What information do we produce and why do we produce it?
Does it tell us what we need to know about our business in order to help us achieve our objectives?
How do we use this information, and if we do not, then why do we produce it?
What information should we produce to drive performance?

The purpose of financial measurement and reporting should be to measure what matters, so as to provide clear information to those running the business to enable them to know what is happening and to indicate what the business will need to do to achieve its objectives. Financial measurement should be seen as a dynamic management tool to enable firms to manage performance and build competitive advantage.

If a firm does not have the internal capability to analyse its financial performance in such a way, and then to find solutions to the problems, it will need to build that capability or look outside for external help. It is often said: ‘if you cannot measure it, then you cannot manage it’. It is not good enough to say (as I have heard some finance directors say): ‘Our system cannot produce that report!’

Currently, the big picture for many has just two priorities: to build and maintain profitability and to generate stronger cash flow. Taking each of these in turn:

Profitability

If firms are determined to increase – or at least maintain – profitability levels, then one way to achieve this is to turn strategic planning on its head and consider the following as an objective:

‘Next year we are going to achieve profits-per-equity-partner of £[…] and every decision we make will be considered and judged in light of how and whether it assists or detracts from achieving this objective.’

This bottom-line driven approach to strategic planning will bring the plans (or lack of plans) of each part of the firm into clear focus and can provide a much-needed financial benchmark for testing strategic initiatives. To do this, accurate measures will need to be developed for producing effective pricing policies, cost estimates for transactions or projects and targets for billable hours and recovery rates. It will also require a firm to have the capability to analyse the impact on profitability of any given proposal before a decision is reached. This may require greater financial modelling expertise to be developed within a firm than is currently available.

In relation to profitability, there is a need to be clear as to what is meant by ‘profit’? Why is it being measured and how will the information be used?

Different measures of financial performance and what they tell a firm about its performance – and why and how a firm should use any particular measure – need to be considered carefully when designing key performance indicators. While terms such as gross profit, contribution and net profit are understood and used by finance directors as measures to evaluate financial performance, how well (if at all) are such terms understood by partners and staff – or even by some managing partners?

There is often a need for financial education throughout all levels of law firms, so that when lawyers are presented with reports designed to help them better manage their practices, they will understand that information and know how to use it. Putting in place programmes for financial education throughout firms would not only be likely to improve financial performance but also make the job of the finance director and managing partner that much easier because partners would then have a better understanding of the financial information being reported and know what they would need to do with it.

Measuring the right things is vital. I have often heard managing partners say they are ‘doing well’ because their last month’s billing figures were good. However, that month’s billings may be the result of a number of unconnected factors which have come together and may have very little to do with the underlying health of the business – or worse, may be based on old work in progress (WIP) and so be hiding a serious lack of new work.

If a firm is producing input figures on a weekly basis showing recorded billable time at charge out rates against budgeted input and on a cumulative basis throughout the year, that firm will know whether it is on budget, and any worrying trends, which may create problems in the future, can be quickly identified and remedial action taken.

On the other hand, if an input trend shows work is continuing to grow, this may call for a decision as to how to cope with that work. Without accurate input figures for each part of the firm, it won’t be possible to judge this. Expensive mistakes may be made by recruiting further staff, rather than first using the available financial information to identify available manpower elsewhere in the firm.

One of the most effective ways to generate additional revenue from available work is to focus metrics on utilisation and recovery. Utilisation rates will reveal where the billable-hour holes exist and where efforts to increase the recording of billable time need to be focused, or where other manpower actions are that need to be taken. Recovery rates will show just how much profit is being thrown away when matters are billed and which of these may require writing off controls to be put in place.

Cash management

As always ‘cash is king’, and at present cash is very tight in many businesses, including law firms. Accelerating cash generation must be a priority for many. However, to what extent do law firms give priority to measuring and reporting on what matters when it comes to cash generation?

If a law firm can first decide what actions need to be taken to generate more cash quickly, it should not be difficult to design measures and produce meaningful reports to monitor, and then improve, cash generation.

So, who needs the information and what needs to be measured?

Depending on the size of firm, cash management will usually need to be delegated down to those managing groups within the firm – or even further.

How far down should delegation go?

The philosophy in some firms is that individual partners and other fee-earners should be primarily responsible for their cash management. Other firms take a different view and place responsibility on the group head rather than the individual, while some firms are centralising the function in order to control it better.

As a principle, if people have responsibility and are accountable for their actions, it is only fair that they should be provided with sufficient and accurate information to enable them to fulfil their tasks.

What needs to be measured will depend on each firm and what it is seeking to achieve. There are some basics, however, which most firms ought to follow to some degree.

Aged WIP

I continue to see many firms produce reports that do not age their WIP, even though many practice-management systems have standard reports for this. How can a firm construct realistic billing targets unless it knows the age of the WIP?

It is also vital to know the trend in WIP, because if it is increasing week-on-week and aging without being billed, then alarm bells need to ring. And old WIP is a risk because the older the WIP then the less likely it is that it will ever be billed. Without this information, a firm is flying blind.

A cash generation plan

If it is to be successful, a cash generation plan will need to be supported by sufficient information to ensure that partners know what is required of them, and the absence of such information is not used as an excuse not to perform. This may include, for example:

Rolling forward cash position targets built around the cash needed to cover all outgoings for the next three months;
Realistic billing targets based on aged WIP and plans to generate cash to meet future outgoings;
Cash collection targets based upon aged debtors; and,
Cash collection reports that may become the basis for distribution of profit to be made to partners.

Realistic and achievable targets, based on accurate measures and reports, will be necessary to achieve success with this, otherwise it will subsequently be difficult to criticise and impose sanctions for failure to perform.

If firms are looking hard at the way in which they measure and report on financial performance, ‘keep it clear and simple’ is a guiding principle to bear in mind.

Whatever a firm is seeking to achieve, it should measure and report on what will help it to achieve its objectives. In contrast, it should try to avoid producing data that serves no useful purpose and only adds to ‘financial information overload’ – a graph can often have an impact far greater than pages of detailed spreadsheets.

Above all, the greater the accuracy and quality of the metrics and reports produced, the greater their credibility within a firm. Not only should this help to reduce genuine criticisms of what is produced, but it is likely to go a long way to ensuring that partners and staff will take notice of, and act on, the reports they receive. If that alone can be achieved, progress will have been made.

Peter Scott runs Peter Scott Consulting and can be contacted at pscott@peterscottconsult.co.uk