Cashflow: surviving the ultimate test

Cashflow is historically a contributory factor in law firm failures, and this is partly due to the partnership model. Because profits are distributed to partners, law firms tend to have relatively low cash balances. Other liquidity challenges relate to the nature of legal work: lock-up (unpaid bills) and work in progress (WIP). According to the Law Society’s legal benchmarking report, the average number of lock-up days for firms of all sizes is 155. HSBC’s survey of mid-market law firms reported that firms anticipate this increasing by 15-25 days for the first six months of 2020.

Law firm revenues are falling amid the Covid-19 squeeze. According to the HSBC survey, firms are forecasting a 10-20% fall in revenue for the 2020/21 financial year. But growth was already slowing before the pandemic hit. The UK legal sector generated revenues of £9.34bn in the first quarter of 2020, down 6.6% on the last quarter of 2019.

Thanks in part to Covid-19, law firms of all sizes are dealing with a liquidity crisis, and like the pandemic this is a global phenomenon.

Priorities for financial management

Law firm financial management right now needs to focus on three priorities: financing for short-term survival without taking on major long-term debt; ensuring that whatever action is taken now does not damage client relationships and business development; and repositioning for recovery and growth when lockdown is lifted.

‘In such uncertain times, firms should do a range of cashflow projections based on different scenarios and monitor performance against those scenarios,’ advises Tony Williams, principal at Jomati Consultants. This is normally a combination of regularly producing long-, medium- and short-term forecasts. An obvious challenge is that nobody knows how long Covid-19 restrictions will continue, so scenarios can include different time frames as well as the possibilities of late payments and business failures among clients and suppliers.

Liquidity – access to working capital – is a key consideration, as debtors and WIP will not pay the bills. Some firms have extended credit facilities and/or renegotiated debt repayments. Listed firm DWF topped up its revolving credit facilities and took on additional debt to provide greater liquidity in the face of Covid-19 challenges.

The government’s Coronavirus Business Interruption Loan Scheme (CBILS) was announced promptly, but the funds were not available immediately and the scheme is limited to SMEs. As Viv Williams, consulting director at Symphony Legal, observes, while some well-managed firms have found this relatively easy to obtain, others were rejected from the scheme and have had to rely on overdraft facilities.

‘Even on the back of a good financial year most firms will have to completely recast their financial assumptions going forward and will need to scrutinise their financial health much more closely,’ observes Peter Lawson, chair of independent Scottish firm Burness Paull. ‘We are fortunate that our financial model is a conservative and robust one. This has been aided by our ability as an independent law firm to respond nimbly to changes.’

Financial forecasting is playing an important role in the firm’s strategy and decision-making. ‘No one can predict the future, but we have been working hard to forecast the impact it will have and how we best mitigate that going forward. We’re doing that on a daily basis,’ Lawson adds.

Acid test

Management guru Peter Drucker wrote ‘What gets measured gets managed’.  

Menzies partner and legal sector specialist Peter Noyce applies the Quick Ratio (or ‘acid test’) for the ultimate test of liquidity. This is calculated by dividing liquid current assets by total current liabilities. Liquid current assets include cash, marketable securities and receivables. The higher the ratio, the greater the company’s liquidity.

‘The Quick Ratio ignores WIP when comparing your liquid assets (cash and debtors) with your creditors due,’ explains Noyce. ‘This is why some law firms – and many businesses – hit a brick wall at the end of March: they didn’t have immediate access to funds because of their cliff-edge liquidity.

‘Firms with a quick ratio of less than 1:1 technically could not pay their debts,’ he adds. ‘So, business models based on a continuation of business as normal, which disappeared in mid-March, will suffer when transactions dry up.’

Strategic approach to WIP

WIP is a key consideration. Noyce considers lock-up days a key performance indicator to ensure smooth and effective cash and practice management and he recommends ‘targeting a reduction in WIP levels, both quantum and days, and debtors to protect the firm’s cash position, especially when focused on deferred tax and VAT liabilities’. However, delays may not be entirely due to firms’ own processes. Tony Williams advises firms to ‘maintain financial hygiene by time -recording, billing and collection procedures but appreciate that some clients, especially in leisure and retail, may be in real difficulty’.

Lawson outlines Burness Paull’s strategic approach to balancing cashflow and client relationships. ‘Clients and sectors are affected in different ways, but a common theme is parties seeking to understand their contract back-stop positions in relation to things like force majeure, contract frustration, termination, insolvency,’ he explains. ‘The same applies to law firms. Any possible option that will help ease cashflow concerns should be explored.

‘This is not necessarily with a view to taking immediate action. In most cases, it is to inform more pragmatic and collaborative dealings with supply chain and customers at an extraordinarily challenging time.’

For smaller firms, tighter cashflow management is key to survival. Viv Williams at Symphony outlines some of the challenges for conveyancing firms. ‘Dealing with landlords and suppliers was an important factor in controlling cash during the early days of lockdown, and agreeing payment holidays and delaying terms was part of the strategy. Chasing down outstanding debt was also essential to cashflow. Many firms recognised that their credit control policy was not as tight as it should be, and the lockdown period has made them realise that carrying large amounts of WIP and debtors was something that had to change forever.’

Partnership perspective

‘Partners should be taking a hit,’ says Tony Williams. ‘Partners own the business and need to appreciate that they benefit in the good times and don’t in the bad times.’ He advised firms to ‘manage partner distributions to preserve cash and possibly link future distributions to cashflow’. Magic circle and many other large firms have indeed delayed or cut partner profit distributions to retain cash. Allen & Overy was the first to call for partners to contribute capital as well as delaying bonuses and pay rises for associates and support staff.

At Burness Paull ‘the firm’s partners have approved a series of measures that will see partner drawings reduced by 25%, profit distributions deferred, and equity partners making a significant capital investment in the firm’, explains Lawson. ‘Ultimately, it is a time for equity partners to step up.’

Many firms that have cut pay and working hours, and furloughed staff privately envisage the likelihood of a reduction in headcount to reflect falling revenues.

However, others are looking to hit the ground running when the lockdown is lifted. ‘We are seeking to retain all staff, utilising the support of government schemes where appropriate, and we are honouring our commitments to taking on trainees and offering opportunities to the next generation of graduates,’ says Lawson. ‘We have colleagues on furlough leave, and this is under constant review.’

Re-examine expenditure

At a recent Managing Partners’ Forum webinar, Jason Adderley of Expense Reduction Analysts advised firm leaders to re-examine their regular outgoings, especially as contracts fall due for renewal – or are usually automatically renewed. For example, some firms have expensive reprographics contracts – with most people working from home, how many printers do you really need? As firms are preparing to return to work post-lockdown, one of the key considerations is office space, which has traditionally represented a significant fixed cost. Initially, introducing social distancing measures will mean fewer people can be at the office at the same time.

Because firms can operate effectively with lawyers at home, many will seize the opportunity of developing new working practices and reviewing ongoing space requirements.  

It is worth remaining flexible and not getting locked into long-term arrangements. Discretionary spend is likely to shift too, particularly as firms’ physical requirements are changing. ‘Identify and reconsider all discretionary spend,’ advises Tony Williams. ‘If in doubt don’t spend.’

As lockdown lifts

Another important consideration is that some law firms (and other businesses) have not yet experienced the full impact of Covid-19 on their balance sheet – or their operations.  

‘Fortunately, many law firms in the UK have an April year end so they should have been reasonably cash positive when the pandemic hit,’ says Tony Williams. ‘Additionally, in recent years firms have been tending to increase partner equity and their bank facilities to give themselves extra headroom. Given the bull market was over 10 years old, many firms had been preparing for some sort of downturn, but I doubt any were expecting a pandemic.’

Noyce agrees: ‘Many firms had a decent run-up to March 2020 and with momentum into April for billings, but it’s the collection of those fees that will restrict partner drawings and current account payouts, where profits were banked.’

‘Some practice areas have seen a fall in demand, especially the more transactional ones such as M&A, property and oil and gas, with many deals being put on hold as the country went into lockdown,’ observes Lawson. ‘Some of these deals may never come back, but we have been encouraged by the rise in new deals over the last month, with a number of deals completing since lockdown. However, as you’d expect we are seeing an uptick in practice areas such as employment, restructuring and banking.’

The shifting regulatory landscape is also likely to produce new instructions for lawyers. ‘Sweeping new regulations are likely to be introduced across a raft of industries in the months ahead, both to deal with situations arising as a direct result of the current crisis and to future-proof businesses against future outbreaks,’ he adds.

Lessons from lockdown

‘Cashflow will also be needed for the business recovery phase, as when work starts to pick up costs will resume too and cash may still be constrained,’ observes Tony Williams. ‘Perversely, the worst cashflow problems can come when the main pandemic is over and things are returning to a semblance of normal.

‘The government’s furlough scheme has been novel and generous. It gives firms time to consider their options and to avoid knee-jerk decisions. However, it will start to be reduced in the summer, so firms need to develop clarity as to their staffing and to communicate that clearly and fairly.’

It is clear that the business environment post-lockdown will bring more challenges. ‘Most firms will need to make redundancies, as will the majority of businesses, but cost-cutting is often the easiest way out and not always the way to build for the future,’ says Noyce, who advises firms to focus sharply on business development to maintain cashflow. ‘It is the ability to feed the business pipeline going forward that will make it possible to phase back furloughed staff without the need for redundancies, and get back to an effective structure.’