Every law practice needs to have some understanding of financial performance. No practitioner can run only on ‘gut-feel’.
Every law practice needs to have some understanding of financial performance. No practitioner can run only on ‘gut-feel’. Instructions from existing and new clients might continue to flow in but unless a systematic analysis of key financials is conducted it cannot be understood if the instructions are worth receiving. At a minimum, of course, various tax offices will inevitably expect a reporting of profits or losses and the ultimate collection of tax on that basis. The decision to adopt one or more Key Performance Indicators (KPI) rests with each practice, rather than being driven by compliance. This article will discuss common types of KPIs and their applicability to professional services.
Almost any financial statistic can be turned into a ‘performance indicator’, however, the critical aspect relates to the first word in ‘KPI’ – Key. Firms should choose a set of indicators that are critical and appropriate for their enterprise.
Each KPI should reflect the firm’s strategy and goals and monitoring the measurement should be integral to the firm’s success and constitute a quantifiable statistic. Few firms are precisely alike. First, let’s divide KPIs by those demonstrating where an entity has been, and toward what goal it embarks.
Historical or Lagging Indicators
Cash received, fees billed effective hourly rate: these are all historical measures of what has occurred. Past performance certainly needs to be measured and understood, but it is also useful to project forward as well.
Forecasting or Leading Indicators
Estimated fees of new matters opened, hours worked, realization rate: these look forward into what might yet be achieved. Of course, projecting is fine – provided we take the time to review the final result, any variance and an explanation for same.
We can refine KPIs further into these three broad types: Business Development, Productivity and Financial.
You may have heard of the 80/20 rule - “80% of the effects are derived from 20% of the causes”. Italian economist Vilfredo Pareto established the concept and it has wide application to business, relationships, wealth and even sport.
A business could easily understand that 80% of income might derive from 20% of clients. What happens however when the ratio becomes 95/5? The decreasing pool of clients puts a business at risk should that client take the revenue elsewhere.
Measuring a KPI like ‘Growth in Top Clients’ could provide an indicator that the revenue base is expanding – a business is deriving income from a broader range of clients that it was before, decreasing the reliance risk.
As a business grows, it would be preferable to generate greater fees from each new client. A professional services firm has some natural limitations on serviceability – specifically headcount. One solution is to earn greater fees per lawyer per client than previously. Average Fee per New Client can be calculated by dividing gross fee revenue by number of clients billed.
Generating new business is accepted to cost many multiples of handling new instructions from your existing client base. The ratio of Client Retention is thus critical – calculate it by number of clients billed over the last 12 months divided by number billed in 12 months prior to that.
Every law firm must understand if their timekeepers and fee generators are productive. While firms often differ between those charging fixed fees, those on billable hours and those who mix the two or provide alternative fee arrangements, the one constant is the input of billable work that will ultimately deliver the inward flow of cash at a future point. No firm can forecast without understanding and monitoring the production process.
Billings per Full Time Equivalent* is calculated by allocating gross billings across different fee earner types, such as partners, associates and paralegals with the goal of identifying groups who are underperforming. You might choose to monitor this in billing value or billable hour value modes.
While important to all, effective delegation is critical for medium and larger practices. Percentage of Partner Hours provides an indication of the ratio partners work compared to other timekeepers.
*Calculate FTE by considering that a lawyer employed by your practice for six of the last twelve months equal ½ an FTE
Firms cannot focus solely on operating revenue and expense alone. Unrecoverable overhead is a reality within every practice.
Average Net Overhead is calculated by deducting non-partner billings from total expenses and then dividing the result by number of partner full-time equivalents. This provides the bottom-line cost that must be covered by each partner before any profit may be derived.
Accounts Receivable Turnover Ratio tracks the amount of time in days each invoice (on average) takes to collect. Calculate it by taking AR balance and dividing by average billings per day.
(Work In Progress plus Accounts Receivable) divided by Average Daily Billings expressed in days
If your annual turnover is $1,000,000 and you have a lock-up ratio of 120 days, a firm could be waiting on the collection of $300K+. That’s four months of work you need to fund before getting paid. Clearly Lockup is one essential KPI.
The three partners of Skinner McAuley Robinson received a smaller distribution of profit than for the previous year. They tasked their practice manager to review the financials and determine the cause and the following figures were derived from the accounts.
For 2018, they had agreed commencing transitioning an employed lawyer to partnership over five years at 20% equity stake per annum, deducted from gross salary but paid back with a 1/5th of 25% profit share arrangement.
2017 year: Gross Fees $1,234,000 Net Income $146,500
2018 year: Gross Fees $1,365,000 Net Income $152,000
There has been a prima facie increase in Net Profit, albeit marginal, however employed staff increased by one and partner count increased by one (a senior associate was promoted to partner on a limited-equity share basis and additionally two staff in total hired). Thus, resulting profit was (partly) shared by one additional partner. The expense of wages was the only expense to have increased beyond forecast budget for the 2018 year. An analysis of the Net Profit Ratio does not shed a lot of light on the reasons for the change:
Net Profit Ratio 2017 = 11.8%
Net Profit Ratio 2018 = 11.3%
Even at a distribution ratio of 3.2 (up from 3 with the injection of new equity) each partner will take a smaller share of the profits. In this scenario the firm would need to gauge if the cost of ‘locking-in’ their new partner is ultimately worth the cost and if increase profits will ultimately arrive.
Key Performance Indicators only serve a purpose if they are directly applicable to the entity concerned and consistency measured and interpreted by stakeholders. Aligning KPIs with the strategy and goals of the entity will ensure measurable progress (or failure) and provide the opportunity for corrective action. Certain KPIs may be lagging and others leading – in order to understand business performance, all should be worthy of consideration.