3 Numbers Reveal the State of Top UK Firms' Financial Health
An auditor analysis of the top 50 U.K. firms' limited liability partnership accounts offers us some insight into their efficiency and progress.
July 01, 2020 at 01:00 AM
4 minute read
Accounting is sometimes derided for being more of an art than a science. Law firm accounting can be even more creative.
Firms can easily manipulate their average profits per equity partner by limiting the number of full equity partners and by including or excluding partners who left midyear, depending on what helps their figure most. And revenue growth offers little insight as to whether a firm has won more premium mandates, hired in more partners or simply received a large payment for a long-running piece of work.
But if we were investors in these firms, we would want the numbers to tell us whether they were becoming more efficient, whether they had improved their internal systems, and how financially prudent they were being.
With that in mind, an auditor analysis of the top 50 U.K. firms' limited liability partnership accounts offers us some insight.
Are U.K. firms becoming more efficient? In the 12 months leading up to April 2019, the average profit margin of the U.K.'s top 50 firms was about 31%, which is where it was two years before. How has this happened? Have advancements in legal technology failed? It was supposed to cheaply handle process-driven work, enabling lawyers to spend their time on more profitable activities.
The answer is that gains in other areas have largely been wiped out by rises in staff costs. On average, the wage bill for these firms rose 6.5%, which means despite revenue growth and operating profit growth of just over 7%, there has been little improvement in operational efficiency.
Lawyer and staff support costs equate to about 40% of revenue on average. And although 11 firms managed to lower these costs as a percentage of revenue, twice that number saw costs increase as a proportion of revenue.
Second, are firms improving their internal systems to bolster their finances? One of the quirks of the U.K. legal industry is that its accrual accounting methods essentially allow clients more time to pay. The incentive for partners to bill is high, but there is little incentive for them to annoy clients by chasing payments.
That means that, as of April 2019, the top 50 U.K. firms were owed just under £6 billion ($7.2 billion). The average amount of time to collect payment was 119 days—about four months. Crucially, this is improving, but progress is very slow. Two years prior, the figure was just under 121 days. It could be a while before this large pile of uncollected cash helps boost law firm finances.
Finally, and perhaps most important given the current market malaise, how well positioned are firms to weather a crisis?
Some firms may perform well during this time, but it is probably safe to assume the vast majority have suffered a steep drop in revenue over recent months. For those firms, the key question will be how much cash they have and how that measures up against their monthly expenditures.
On average, the top 50 U.K. firms had just over £30 million ($36 million) in cash and a monthly wage bill of about £13 million ($15.7 million). Based on the numbers at that point in time, 15 firms had less than one month's wages on hand. Only 14 firms had more than three months' wages.
Firms will clearly need bank loans and overdrafts. As of April 2019, two-thirds of the top 50 firms had some form of debt, which amounted to an average of about £23 million ($28 million), a number we can expect to rise.
Perhaps the most concerning thing is that the worst is yet to come. We are currently in the middle of the 2019-20 reporting season, which will only give us a small indication of the impact of the pandemic. But the tax bill for U.K. firms is due Jan. 31, 2021. That is when their cash balances tend to be at their lowest. That is when their ability to improve efficiency, collect cash and remain financially secure will really be tested.
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