With rare exceptions, the practice of law is a business, and legal services are a product. To improve law firm profitability, think of your firm as a manufacturer. If law firms want to remain sustainable, they must prioritize profitability by balancing production volume and cost efficiency. Making data-driven adjustments can enhance cash flow and profitability, ensuring sustainability for the firm and improved services for clients.
Improving Profitability as a Law Firm
Legal work is often viewed as a series of customized, one-off solutions. On the other hand, treating many repeatable legal matters as a manufactured product coming off the assembly line allows firms to analyze and refine their processes systematically. By documenting, implementing, measuring and refining workflows, law firms can:
- Better utilization of leverage for newer attorneys or non-legal professionals on less complex tasks
- Better focus on what is truly unique in each matter
- Define the “secret sauce” of your law practice and apply it across all matters
- Price services more accurately to ensure profits
The key metrics that you’ll track for law firm key performance indicators (KPIs) are production, cash, financial and pipeline. This is known as profit-focused accounting, which breaks revenue down into financial and non-financial drivers to help business owners fully understand their cash flow. Within each of those distinct areas, a multitude of levers are available to pull that enable your firm to achieve the benefits listed above. Contingent and hourly billing law firms can both find actionable tips below that can help improve cash flow and overall profitability.
Production
Production Vital Signs for Hourly Billing Firms:
- Average bill rate/realization
Production Vital Signs for Contingent Fee Firms:
- Average matter length from intake to adjudication
Mapping out legal workflows with defined milestones helps establish structured, replicable processes that enable you to quickly identify bottlenecks and areas for improvement. Case management and task tracking will also improve as a result of more effective workflows. Automation tools can enable more efficiency, while practice management software, like Filevine for PI contingent firms or Clio for hourly billing firms, can help keep your administrative tasks to a minimum.
Workflow Process for Case Management
Your workflow should pair case milestones with actions taken, documents needed and the timeline for when they’ll be finished. Milestones serve as a superstructure for your processes, becoming a common index across different matters. This will serve you well when it comes to evaluating the process and, eventually, replicating it. When you lay out each step – from “matter referred/client intake” to “petition filed” to “case closed” — you can see exactly where a holdup or roadblock occurs, creating more opportunities to improve.
This view also shows you how often actions are repeated, and documents are reused throughout the process, enabling you to create templates of often-used documents to shorten the time each step takes to complete. Inform clients about your milestones and the timeframes they can expect for action items: if you can stick to that, you can create a narrative for the client that you can live up to. They’ll happily pay and likely refer you via word-of-mouth due to their own positive client experience. You’ll also be happy with a workflow that’s much more standardized across the board, saving you time during onboarding and training new attorneys, paralegals and staff.
Cash
Cash Vital Signs for Hourly Billing Firms:
- Cash on hand (General account)
- Average days in AR
- Total days in WIP and AR
- WIP
- AR aging
- Line of credit
Cash Vital Signs for Contingent Fee Firms:
- Cash on hand (General account)
- Prepaid case cost
- Line of credit
Cash is king. As a general rule of thumb, law firms should keep at least two to six months’ worth of operating expenses, including partner draws, on hand at any given time. And it is incumbent upon the firm to distribute income tax money out to the partners to pay their estimated taxes, which should be about 40% of your forecasted net income.
A minimum of 10-30% of forecasted revenue should be set aside as working capital. Determining your risk factors will help you figure out whether the 10% or 30% option is better for you, although realistically you’ll select something in between those goalposts and may adjust that percentage as your firm’s goals progress. Risk factors include the strength of your pipeline, the number of partners, the age of the partners, whether your firm is planning to make big investments in technology or geographic footprint in the near term and more.
Improving Your AR and Billing Cycle as an Hourly Billing Firm
You can’t eat work in process (WIP), and you can’t eat accounts receivable (AR). If you don’t bill, you don’t get paid and realistically, what good is that for your profit margin or bottom line? Your billing process and collection policies need to be set up and enforced. This means training your clients to be “A” clients. Follow up with clients to ensure they are paying their bill within the timeframe established in your engagement letter to help prevent them from developing poor payment habits. This also helps enhance your client relationship and retention rates, while still protecting the financial health of your legal practice. You should also check with your partner group to verify when and how they bill. It is not unheard of to find at least one partner who only bills one or twice a year. It is unfair to the other partners who are financing that bad behavior, so you must enforce those policies.
Your firm may be able to avoid cash going negative or hitting your line of credit by shortening your AR collection cycle from 60 days to 45 days, for example. Even better, a 30-day turnaround will also provide improvements and may be more realistic for most clients to adhere to. Establishing a consistent billing hygiene and a follow-up process, for example, could help mitigate emerging problems.
Financial
Financial Vital Signs for Hourly Billing Firms:
- Revenue per professional
- Gross margin per professional
- Actual charge hour expectations vs expectations
Financial Vital Signs for Contingent Fee Firms:
- Number of client matters
- Gross margin per professional
What should your net income be? The general rule is 30-50% net income as a percentage of firm revenue. If that figure gets closer to that fifty percent mark, and even above it, make sure that you review that decision. Have you missed any opportunities to invest back into the firm through infrastructure or adding new professional talent? Could you invest in more training for your staff? You want to ensure your firm’s profitability can continue sustainably rather than simply extracting value from the firm. Net income of 60% or more can indicate that you have no intention of growing beyond you, so when you retire or pass away, there is no firm to sell or transition and there’s no legacy to leave behind.
One way to boost your net income is to review charge hour expectations for your firm. If your usual charge hour requests are 33 per week, asking every employee to increase their charge hours by two can provide a serious boost to your net income. For example, if a firm employed 10 professionals and asked each to increase their billable hours by two a week for a firm-wide total of 1,040, with a $250 standard rate and a .9 average realization rate, you could increase net revenue by $234,000.
Combine this with increasing realization by 5% and you could potentially see up to $247,000increase in expected net income. You may also incidentally improve realization if you simply review and tighten up your processes to better utilize your financial data.
To help retain staff at elevated hour request levels, consider offering benefits like an extra week of paid time off. You can also explain the benefits of their actions and explain that they are not just doing those extra hours to make the partners some extra money. Rather, especially if they are a younger attorney, they are building their expertise and reputation. Inform them that their first five to seven years will define the next thirty years of their career.
Financial Statements
Use the accrual basis to prepare your financial statements to match your revenue with expenses. Note that you will still pay taxes on a cash basis. The important thing to note is that the cash basis follows the accrual: If your WIP and AR are trending down, your cash basis income will also trend down. Track your financials on the accrual basis then convert to cash so they can be compared and monitored year over year. The reliability of your financial statements is key. While Generally Accepted Accounting Principles (GAAP) may be useful for law firms with high amounts of debt, a sort of “GAAP Light” is more appropriate for most firms. Your financial statements should also be standardized for professional services firms to enable you to benchmark your firm against similar firms in your area.
Pipeline
Pipeline Vital Signs for Both Hourly Billing and Contingent Fee Firms:
- New client opportunities
You must determine your capacity to determine how much pipeline you need. Capacity will tell you how aggressive you can be when pricing new work. Better processes can also lead to more efficiency, increasing capacity overall.
Keep in mind the manufacturing analogy: you are building a product for a client. The first part of the process is the initial interest and meeting. Consider where you get your work: are you thought leaders, are you using traditional advertising or are you relying on referrals from other attorneys? Track where new leads come from. Track the phone calls, track client meetings to determine who is best on closing, and then what results from a signed engagement letter. A CRM system can help you track your client intake, helping you make more informed decisions that better fit your clients’ needs and leads to better client satisfaction.
Ask questions like, “Why did they call us?” and make value judgments like, “Is the matter they’ve brought to us work that we want?” Focus on the data telling you where clients come from, why they are calling, what kind of work they are requesting. Is the work they are asking for part of your practice area? If not, why is it that they came to you?
You should also track your closing percentage and determine your average sales cycle. If closing percentage is fifty percent on a capacity of $300,000, then you will need a pipeline double that. Determine your capacity, determine where the work is coming from, what’s the total potential value of that and then you can back into, based on your close rate, how you are going get your pipeline determination.
Law firms can achieve sustainable profitability by treating their legal services as a structured product, optimizing operational efficiency, enforcing billing discipline, and leveraging financial data for strategic decision-making. Focusing on production, cash, financials, and pipeline as your key metrics can help streamline processes and enable a more stable and profitable business.
If you found this blog post helpful, we invite you to learn more about our Virtual CFO services for law firms.
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