This article is written by Aditya Srivastava of team iPleaders.
The newspapers of May, 2012 shocked the entire legal and financial world when international law firm Dewey and LeBoeuf with 2500 employees all over the world filed for bankruptcy, terminating its operations. On a closer study of this story, it was found out that Dewey was about in $245 million international debt and $315 million worth liabilities sufficient to overshadow its assets worth $193 million.
Dewey and LeBoeuf is a classic, but very notable example of what happens to law firms when financial planning is done badly. If the reports are to be believed, Dewey went on a lateral hiring spree by luring the experts on the promise of high pay and extended contracts, leading to huge mismanagement of about $300 million debt. Even in 2008-09, when the business of the firm was on a downhill, they doubled the hiring of highly priced partners, which they could not manage later, leading to its ultimate failure.
Even though your size may be very different, every law firm is always balancing the hunger for growth and the need for not rocking the boat too much. Should you hire another partner laterally? How much should you offer? Should you hire a bunch of junior lawyers? Should you open another office in another metro? Should you pay a hefty amount to a management consultant or just go with the flow? Should you organize or sponsor some big ticket events, when acquisition of clients through such activity in uncertain? There are tons of things vying for more budget in every growing practice, and where you channel the mullah is probably going to decide the future of your firm.
Also, you need to keep in mind the vagaries of the market. Practice areas are always rising or falling in relative importance or profitability. If venture capital practices grew like multiplying rabbits in 2015-16, 2017-18 has not been very rosy on that front. How aggressive or risk averse should you be, and in which areas, is to be carefully planned, debated, finalized and then fine tuned as more information becomes available. However, this plan cannot be in terms of vague hypothesis written in terms of broad principles like mission and vision. This plan has to be a financial plan to be effective.
Growing a law firm is a painful process, a constant struggle to correctly predict which way the economy and markets will move, to prepare for it and execute to take advantage of the opportunities and give a miss to the sinkholes, retaining old clients and luring in new ones, meeting hectic deadlines, retaining the best talent and firing some, keeping the partnership intact and dealing in an extremely competitive market and a lot more predictable and unpredictable things. What has to be done cannot be dictated by moment-to-moment decisions. Those who run a law firm need a compass and a map. They need a financial plan. They should be able to measure performance against the projections, and adjust the sails and manpower according to how rough the sea is, which way the wind is blowing and how far they have to travel.
A law firm is lost at the sea unless it has a good financial plan to map its progress against (but the captains and mates may not know how lost it is yet, except that they may have an overpowering sense of uncertainty that the people at helm often experience).
We must not blame lawyers for not knowing the basics of financial projects and not doing enough planning for growth. It is not something that most lawyers ever get to learn formally, though they are expected to run big and successful law firms.
What are financial projections?
Financial projections are essentially the quantification of a business plan which is aimed at predicting the organization’s expenditures and income in future timeline. They are the forecast of incomes and expenses, which a company expects to undertake during a specified term. It is a part of business planning, which typically takes into account various internal and external factors such as the financial history of the firm, cost data analysis, examination of factors of external market, estimated forecast of financial figures, thereby leading to estimated projections of the financial well-being of the company.
Simply put, financial projection is the prediction of the financial health of the company.
A classic financial projection includes forecasting of income statement, balance sheets and cash flow statements. A long term financial projection is for 3 years and projected over year to year basis and a short term financial projection is spread over 1 year, with projections outlined over every month. An ideal planning would require both the projections with key focus on short term projection which should determine the strategic goal of the company.
One might argue that financial projections can be just used by the law firms which have been running for at least one year to at least compile internal and external accounting data and last year review which most of the law firms entering the market won’t have, however that is not true. Financial projections can be called envisioning your business plan or setting up your goals in numbers on the basis of your potential. This becomes an excellent source of guidance and ensure that the law firm is moving in a planned direction.
Importance of Financial Projections
Financial projections are not only an important planning stage of your law practice/ law firm, but also a critical tool to bring other competent people on board. When the financial future of the firm has a powerful representation through numbers, there is a great chance that other legal experts, senior employees, potential partners etc will be more interested in joining you an making your vision come true. Even if you intend to raise any loans or line of credit to expand your firm, credible financial projections will go a long way to get the interest of banks and institutional financiers.
When things are not going well at your firm, and you consistently miss projected figures by large margins, it is also an important red flag that helps in course correction before it is too late.
Types of Financial Projections
Consolidated monthly balance sheet forecast
This document would put your assets and liabilities on a weighing scale and give you a holistic view of your business. This would include capital expenditure, which are usually the investments that you might want to undertake which would not be a part of your day to day transactions. You would be able to predict the capital expenditures you want to make throughout the year on this document. The balances from your profit and loss account would also be brought down here, to give you an estimate of what maybe the due receivables/payables you have estimated throughout the year. In such case, a balance sheet forecast helps to realise what assets are available with the law firm and what could be the possible liabilities which they could afford to add to their books for chasing more growth and what would be too much risk.
A successful law firm is the one who knows what market it can serve best and who are the ideal clients. A client forecast is essentially prediction of monthly revenue generation from various clients, and could be an exercise that is done for every team or departmentwise, and even for each partner separately. For regular clients, this may be easy to do. This is very useful as it helps in better resource/team and budget allocation. For instance, if you have a large client who brings enough work every month so that you know that every month you can bill them for approximately 70 hours or more, this really helps to decide whether you need to hire a new person or stretch existing bandwidth to serve this client.
Here is another example. If you have been approached by a certain client regarding a certain M&A which may take about 6 months to be accomplished, and most of the work will happen between the 4th and 5th month, and the total requirement is likely to be of 200-300 hours, you can plan your resource allocation very well. You can plan the allocation of team members for this project, you can calculate the net profit that this project will bring and whether you will need more hands on board, and whether you need to invest more time and effort to make your associates more efficient.
Are you going to need dozens of new associates to handle the work that is coming in, or got lined up over next few months? Great, can your office accommodate them or you need to lease more space? Do you need an HR manage if your headcounts are increasing? Do you need to keep paying outside recruiters or should you hire an in-house recruiter? There are a lot of strategic decisions to make at this stage.
Cash flow prediction
Whatever you bill every month is not going to hit your account. Indian lawyers often say that they recover about one third of their total billables every month. This is why cash flow forecast is one of the most crucial yet critical aspect of financial projection. All the expected cash transactions are broken down on weekly and monthly basis, and sometimes divided into daily expenses record. This projection acts as an immunity against any financial hazards, as a regular check on it can help the law firm to identify the potential issues and take timely action.
For example, you might have a regular client who in the past have brought in immense business but have suddenly started delaying the payments. That may put some stress on your cash flow as income is uncertain while expenses remain the same. Do you need to find some additional clients at this point? Knowing where you stand helps to make quick decisions. A constant update about the cash flow could help you understand this difference of pattern and might save you from a future loss.
Consolidated Monthly Budget
This is a consolidation of all your costs to meet the targets that you have set in the 12 months. This acts more or less like the domestic budget and includes all the expenses that you can undertake in the coming fiscal year. Further, it will also keep a check on whether your spending is concentrated on a certain area or spread across alike in order to ensure that your money is flowing in the right direction. For example, you might have a current case on real estate with heavy expenses. However, it is the M&A team which generally is the biggest revenue generator during the rest of the year. In such circumstances you need to ensure justifiable budget allocation between the real estate and M&A team. Even bonuses may vary depending on who works on which team. This would also help you distinguish between fixed and variable costs involved and how and where you can cut costs for effective management.
Why is Financial Projection Needed?
While I can think of a lot of reasons, the three biggest reasons why you need to get a competent person to prepare a financial projection for you are as follows:
Financial plan breaks down the law firm’s goals into small achievable targets
A financial projection is not merely a prediction, it is essentially assigning yourself with smaller, manageable tasks and committing yourself to achieve them. The financial projection is the definition of what “being successful” which you are getting to define. Once defined, it can be communicated with a larger team and the entire team can rally behind you with these clear targets on mind. It is essentially setting up milestones for your law firm so that you can later ensure that those milestones are duly achieved.
Red-flagging problems and mitigating risks.
Any deviation from the projection can be a warning of some impending problem that would need immediate attention. Projections act as a guide in determining such deviations through their well designed framework and can help you implement risk mitigation tools at the right time. For example, if your hiring projection is being met while your revenue targets are missed, it’s alarming. You have to now decide whether to continue hiring or let go of some people since you were not able to increase revenue as originally planned.
Anticipation of problems and solutions beforehand
You might lose a client, your partner might back out at the last hour, there could be rapid cash shortage in the market – your projections should be flexible and stringent enough to cover up all these aspects and prepare you for the worst. It thus gives you the a very good idea as to where you stand or what could go wrong and provide you contingency plan to be sustainable in the darkest of hours.
How to perform Financial Projection
Nipun Bhatia, AVP at Legal League Consulting has been doing financial projections for quite some time now. He simply explains the process in one line, “Keep your targets conservative and revenues stringently constant. Realistic expectation setting is the only key to perfect financial projection.”
Following is a step by step procedure to make a perfect financial projection.
1) Envision your business – Set up a goal
You could be a leading law firm, with diversified area or a firm which is just entering the legal market. You need to decide how exactly your business needs to look like. You need to establish your core practice areas and recognize your clients even before entering the market, and strategize to reach out to more. You also need to set up an expectation for yourself as to how much time would you need to reach that goal and what will be the steps you would take to achieve it.
2) Identify the variables
Variables are those factors that keep changing, and may or may not get affected by your business strategies. Essentially all the values that come in your profit and loss accounts are your variables. For example, income sources, regular expenditure, salaries etc. You need to identify them and mention them in the forecast so that at the time of them taking effect, they do not disturb your projections.
3) Study the past trend
You need to study the past trends of your business and plan accordingly. You should know exactly when the market for you goes up and when would you need more resources or when would you want to let go of redundant resources.
For example, you might be considering whether you should expand your team of 10 lawyers to 13 in April. If as per the past trend your work is at its lowest in May and at its peak in August, you might want to hire in the month of July so that revenues in August can monetarily accommodate and provide them with adequate workload.
4) Estimate your income and costs
It is a common practice for law firms to recognize the clients and predict the revenue generation on a quarterly basis. For example each partner or associate is assigned with a target to ensure X amount of client billing. This estimation would set target for rest of your team and help you assess their performances individually as well.
You now need to reach a point that you identify what are the fixed costs that you need to incur irrespective of any up and down and how will you manage that. For example factors like rent, electricity, wages, etc are all a part of this estimation which would be a part of your expenses.
This proforma would form your estimated profit and loss statement. You can find a sample profit and loss account here.
5) Create your budget
After all of this, you will need to create a budget, to understand how much it is going to cost you to actually meet the targets you have set in the goals. Include everything right from the variable (promotions, incentives, client entertainment etc.) to fixed costs (rent, salaries etc.). Things like interests and taxes should be a part of this projection too. Remember to go by simple mathematics and be realistic in your approach. An established rule says that lower the fixed costs, lower the risks. Thus, make sure that your fixed costs are effective and utilized and your variable costs do not go overboard.
6) Break-even analysis
The breakeven point is that point in your business when the expenses incurred are sufficient to match your gains, with no profitability. “This projection should be your worst case scenario and your sole aim should be to not come down this level.” says, Ranjeet Kulkarni, Partner and CA at G D Apte & Co., Chartered Accountants. This analysis is required for you to figure out at what point your investments/ expenses would equate your earnings, and how do you need to trigger from that point to reach profits. You could call break even as your half way goal in a month, which needs to double up by the end of the month.
7) Assess your assets and liabilities
This would be in form of a projected balance sheet. Assets and liabilities are those which do not go into the profit and loss accounts and are contributors to the net value of your law firm by the end of a fiscal year. These are necessary to analyse whether there needs to be any new investment or not or how far has the firm managed to discharge the liabilities, if any. You can find sample balance sheet for your financial projection here.
These steps cover financial projection for law firms and law practices in general. However, these steps are taken by all professional firms. Partners at various law firms these days spend a significant amount of time in projecting the finances and failing massively at it or hiring external experts who often are not able to understand the real business dynamics of that particular law firm. It is advisable to get a thorough knowledge of financial planning for at least one or two partners in a law firm who can then guide the rest of the partners to arrive at a reliable financial projection. A good way to do it is through taking up this course, by National University of Juridical Sciences which will not just help you with financial projections but also give you a good insight to develop your business plan.