Trial Magazine

Whether a lawyer is starting a law firm, actively engaged in law firm management, or just ­evaluating a firm’s finances, it is important to understand and assess the law firm as a business­. By looking at a few standard reports and metrics, you can check on the health of the business, its future prospects, and its compliance with client trust account requirements.

Core Financial Statements

Several core “big picture” financial statements can give insight into a firm’s income, assets, and cash flow. Larger firms may have full-time financial advisers, and smaller firms may hire contract accountants and bookkeepers—but lawyers, especially those in firm management, should be knowledgeable about these basic business statements. A good way to begin is to reach out to a professional familiar with the practice of law for a rundown on the different tools. ­Alternatively, a Google search for “understanding basic financial statements” will yield an almost endless variety of reading material. For example, the U.S. Securities and Exchange Commission’s guide, written to help investors evaluate the financial health of potential ­investments, is a good starting point for understanding the financial health of a law firm.¹

Income statement. This answers the question: “How much money did I make?” Every law firm will have slightly different income and expense line items. Some law firms might break out different types of labor costs (contract labor, administrative labor, and attorney labor) whereas sole practitioners, for example, would not. But regardless of the specific labels, the income statement will show all business income and expenses—the firm’s legal fee revenue, labor costs, rent, subscriptions, bar dues, taxes paid, and net profit. It shows where your income is derived from, where your money is being spent, and your firm’s overall profitability or lack thereof.

Balance sheet. This answers the question: “How much is my firm worth if I sell everything and pay my debts?” The balance sheet shows the firm’s total assets and how these assets are financed through debt or equity. It lists the things that your firm could sell and the money that you owe. A typical balance sheet includes

• current assets (typically liquid assets, such as cash on hand and accounts receivable)
• long-term assets (tangible items, such as real estate assets, vehicles, computers, and furniture)
• current liabilities (amounts you owe with payment terms of less than a year, including any of the firm’s accounts payable or credit cards)
• long-term liabilities (any amounts you owe with payment terms of more than a year)
• equity (the amount of capital that firm owners have invested in the business, whether to start the business or to sustain the business during periods of unprofitability).

Cash flow statement. This answers the question: “Can I pay my bills?” The cash flow statement lists the money coming in and the money going out and ties the income statement and balance sheet together. It shows how much cash is generated and used during a specific time period.

The cash flow statement is ­typically broken into three groups: operating activities, investing activities, and financing activities. The operating activities section closely follows the income statement, but you want both an income statement and a cash flow statement because the cash flow ­statement records all overall changes in cash during the fiscal year, rather than just profits and losses.

The investing activities section of the cash flow statement shows cash spent on assets of the firm, while the financing activities section tracks the funds received from equity and loans and any repayment or dividend paid. If, for example, a firm were to pull $250,000 from a line of credit, that would appear as a $250,000 entry to cash flow (and a $250,000 liability on the balance sheet). Conversely, paying off a loan subtracts $250,000 from the cash flow.

Accounts receivable. This answers the question: “Who owes me what, and when is it due?” The accounts receivable report measures how much money is owed to your firm (such as a case that has been settled but not funded) and for how long. It lists all of your settlements along with how much you are owed, usually breaking down the amounts due by their current or overdue status. Generally, these are tracked on a 30, 60, and 90-day overdue schedule. But if that does not fit your firm, the important thing to do is to track this report so that you can be aware of any status changes.

This means staying on top of past-due emails, phone calls, letters, or even suing to enforce a settlement agreement. Tracking and following up on accounts receivable should be a part of the firm’s culture because as past-due accounts age, the likelihood of payment becomes more doubtful. While the individual amounts owed to your firm may seem small, they can accumulate over time. Staying on top of these charges regularly will help keep your books manageable.

Outstanding client expenses. This report answers the question: “How much of the firm’s money has been invested in any case or client?” It displays the funds that your firm has outlaid for a particular client along with any repayment of those funds, either in full or in part.

Note that this report tracks only the money invested by the law firm. If a client has paid the expense on his or her own (for example, by obtaining medical records), then that will be captured on your list of case expenses. But it would not be included on your firm’s outstanding client expenses report because these expenses are not firm assets—they are not owed back to your firm.

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Where Should I Keep This Data?

Best for Most: QuickBooks is generally the best solution for financial data collection, storage, and reporting. It is relatively easy to use, and it is a very stable platform. Because it is used across many industries, it is easy to find contractors to assist you in entering data or generating reports.

Good and Free: If QuickBooks is more than you need starting out (we suggest reexamining this likely incorrect belief), Google Docs is free, and many templates are available to get you started.

Probably Not the Best: There are vendors out there that sell every form of proprietary and semi-proprietary solution for law firms—financial reports are no different. These solutions can be expensive, time-consuming, and subject to the continued availability of the vendor. For these reasons, you should think very hard about using any form of proprietary software for your bookkeeping and financial data.

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Tracking Finances

Once you have the big picture ­financial statements in place, turn to the following metrics to help you keep track of the money you have, the money you should be receiving, and the time it will take to receive it. Also factor in the time that usually passes between reaching a settlement and receiving the funds from it—sometimes it can be months.

The overly optimistic estimation of this metric is a major pitfall for firms. When a firm handles a case, that case has an expected value and an expected date of funding. The dates of settlement and of funding are both important for planning and profitability.

Take, for example, a case that is worth $20,000 to your firm. If you anticipate funding in one year with 30 lawyer-hours expended at $200 per hour, that results in a significantly different value to the firm than funding in three years with 90 lawyer-hours expended at $200 per hour. The former produces a profit of $14,000 in one year and the latter a $2,000 profit in three years.

Average days outstanding for receivables. Calculating your firm’s average days outstanding for ­receivables is straightforward. For fee-producing cases, determine the time period between when the fee was earned or invoiced and when the payment was received. This backward-looking number should be tracked and, hopefully, trend downward over time.

Also use it for forward-looking budgets and plans. There are several helpful software programs you can use to determine this number for your firm, such as Bench, QuickBooks, or Sage Accounting. You need to have a good grasp on what you are owed and when payment is expected to avoid cash flow problems. If you need the settlement money to make payroll, for example, 30 days makes a significant difference.

Average client expenses and labor costs per case. The best source for calculating average client expenses and average labor costs is past experience. No two firms are the same, but if you are new to a practice area, you can look to others in the field for guidance on how much money and time they spend on their cases.

Beware, however, as the value of that information depends on the source; because most lawyers do not track these financial metrics, this information could be wildly inaccurate. Regardless, it is important that you have a budget for costs (and time) on a particular case or case type and ensure the case is economically viable. For most lawyers, labor costs and case expenses represent the largest component of their variable expenses. Understanding these numbers allows the firm to approximate the return on investment for individual cases, informing everything from staffing to case selection to marketing budgets.

Handling Client Funds

Having a basic understanding of how a client trust account works is a must. Every law firm has a fiduciary duty to keep client funds separate from business funds. Client funds should always be kept in Interest on Lawyer Trust Accounts (IOLTAs) (and are required to be kept in these accounts in some states).2 IOLTA funds never should be used for business purposes, and your firm’s funds never should be comingled with IOLTA funds. Violating your jurisdiction’s IOLTA rules can result in disciplinary action.

Requirements related to client trust accounts vary by state, and different jurisdictions have distinct rules as to when you can and cannot withdraw money from an account and how you can use it. Therefore, it is critical to ­understand your state’s requirements to avoid any penalties. However, here are some generally applicable practices for having and using IOLTA accounts:

• Work with your bank to charge all IOLTA banking fees to your ­operating account.
• Reconcile your IOLTA account regularly.
• Create custom reports in your accounting software to easily and quickly identify which clients have money in your IOLTA account and to maintain a ledger of each client’s activity.
• Before disbursement of funds, be sure the deposit has fully posted to your account.
• Confirm that any disbursements are in accordance with your contract with the client.
• Report your IOLTA compliance to the state bar, if applicable.

Looking to the Future

As your firm grows, step back and look at the big picture of where you want it to be. When expanding your business or just looking to your firm’s future, consider the following.

Cash flow planning. Make sure that you have enough cash flow for an emergency. Understanding what months may be slow due to holidays or court closures can be useful so that you can avoid spending in those months or save for them in other, more profitable months. As your business grows, look at past years to see whether there are any trends you can anticipate in your cash flow forecasting.

Debt financing. Typically, banks are the major source of business funding. However, other sources to consider are savings and loans, family members, friends, and commercial finance companies. Debt financing is one option to help grow your firm, but it can be risky and expensive because the individual or institutional investor becomes a creditor and receives a promise that you will repay the principal and interest on the debt.

Cash reserves. Have cash reserves on hand in case of financial emergencies or lulls in your business. Using the cash flow planning strategy described earlier will help you to predict when these lulls may occur and how much of a reserve to have. A good rule of thumb is to have enough cash to cover six months of expenses.

Budgeting. Although you should have a budget in place before starting your firm, keeping it updated and revisiting it are critical to maintaining or growing your business. As your business grows, you need to have a solid idea of how much work, time, and money you must invest to keep your firm profitable. Budget for fixed costs (such as payroll, utilities, rent) and variable costs (such as travel, marketing, taxes)—but also add in a cushion for these expenses.

A budget can be as simple as creating a spreadsheet or as detailed as using automated budget software like QuickBooks. How you set up and manage your firm’s budget will ultimately depend on your preferences. In addition to serving your clients, a law firm is a business—and it’s your responsibility to ensure that your business is financially stable and poised for growth.

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Charles D. Brown is the managing partner and Arianna Barker is an associate at Brown, Christie & Green in Houston (www.medmalfirm.com). Adam Carlson is the founder and CEO of AC Partners Inc. in Houston and can be reached at adam@acpartnersco.com. The views expressed in this article are the authors’ and do not constitute an endorsement of any product or service by Trial or AAJ.

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Notes

1. U.S. Sec. & Exch. Comm’n, Beginners’ Guide to Financial Statement (Feb. 5, 2007), https://tinyurl.com/y6vrvlrx. 
2. Carole J. Buckner, IOLTAs and Client Trust Accounts, Am. Bar Ass’n (July 31, 2011), https://tinyurl.com/yf5kfaby.