By Andrew Chen, Partner - Business Advisory, Crowe Horwath
Typically, the responses are given in the context of the current economic conditions the firm is facing, internal issues or a partner’s objectives.
How would the partners of your firm rate the financial performance of the firm? Do some of the following responses sound familiar?
- We grew revenue by 10% again
- Partner profits exceeded expectations at $600,000 per partner
- The firm was valued at $5 million
- Staff productivity is at 85%
- Profit per point is on budget
- Cashflow is great our firm lock-up is now 60 days.
- We just hired a new a partner and opened a new office in Brisbane
In contrast, for a firm not travelling financially well, the responses typically centred around the firm not meeting budgeted fees, the reasons why and the level of partner profit draws not being quite where they should be.
Understanding how your firm rates financially is important so that you know the true financial picture. This can be achieved by using a composite of measures that highlight the strengths and weaknesses of the firm, but also provides the firm with actionable insight to change its future direction.
Most firms produce monthly and annual financial statements including a Profit and Loss Statement and a Balance Sheet in order to comply with tax and other record keeping requirements. But we tend to analyse them in isolation, and track measures specific to particular balances or reports. While there is nothing wrong with that in itself, it does not show the true picture of a firm’s performance.
It is important to analyse the financial relationship between a profit and loss and balance sheet together to truly know how your firm financially rates.
I have come across a number of similar instances where a partner has said: “The profit per partner was $350,000 and we had a great year, but each partner had provided effectively $800,000 of equity funding to the firm”. In my book, that’s not a particularly good outcome.
Create a firm scorecard
Create a firm scorecard with your firm’s key KPI’s with targets and compare them to benchmarks from the recent ALPMA/Crowe Horwath Financial Performance Benchmarking Study ‘Financially propelling innovation & growth’. From the results summary,you can rate the performance of your firm, and assess if it is above expectations or performs poorly.
1) Gross Profit Margin % (GP)
I was quite surprised at the number of firms that do not budget or report their gross profit margins. This may have something to with how a firm’s accounting system and payroll systems are initially set up, and an acceptance of the reporting produced by these systems.
It is an ideal measure to see how profitable the firms legal service are produced, which then should direct you to whether you can afford those pay rises, increase productivity or change staff mix or simply need to grow fees.
The recent ALPMA/Crowe Horwath Benchmarking study results indicate that the average GP in June 2016 was 57.8% and it has hovered around this percentage for the prior 3 years.
2) Profitability % (before interest and tax)
Everyone looks at the bottom line, but not always before interest and tax. This measures the operating performance of the firm as a return on revenue. It enables your firm to be compared to the performance of other firms regardless of how the firm is funded.
3) Return on the funding capital %
This measure is also commonly known as the return on capital employed. [Profit before Interest & Tax / (Working capital + Non-Current Assets)]
Is the profitability percentage an adequate return for the amount the partners have invested in the firm and the firm has borrowed from the bank? If the answer to this question is no, then this could be a reflection of large work in progress and debtor balances, low gross profit or excessive overhead costs.
This measure provides your firm visibility on whether the partners are leaving excessive profits in the firm; bank debt is growing due to poor working capital management of WIP and debtors; or whether there is a committed investment for growth.
4) Revenue generated on funding capital % (Financial Resilience Index)
We see this measure as an indicator of a firm’s financial resilience and how effectively the firm is able to grow fee revenue off the back of the funding from the bank and the partners. That is the firm’s ability to support fee growth with no extra funds from the bank or profits left in the firm by the partners. On average, firms in the ALPMA/Crowe Horwath study generated for $2.7 of fee revenue for every $1 of funding.
Increasing the value of the firm
Other measures and indicators improved such as lock-up days, partner draws increased, bank debt reduced and overheads were contained.
For participants in the ALPMA/Crowe Horwath study that rated highly in the above four measures relative to their peers, it was no surprise that the results also showed they were being innovative and were also investing in marketing campaigns and new technology.
How does your firm financially rate on these measures?
About our Guest Blogger
Andrew helps business owners identify key financial issues affecting their businesses and then develops tailored solutions to make their businesses more profitable and sustainable.
Andrew’s significant experience in advisory and tax accounting services comes from working with businesses of all sizes. He specialises in advising legal and professional service firms on establishing business structures; financial management in areas of internal accounting functions and tax administration; financial reporting and KPI performance measurement; budget and cash flow forecasting; tax planning; salary packaging; and tax return preparation.
Andrew is a regular speaker on financial management and taxation issues at industry events. He was a key speaker for Macquarie Bank’s National Legal Firm roundtables. Andrew lectures at the College of Law and also contributes to industry publications including those for the Australian Legal Practice Management Association and Australian Dental Association.