Looking at market trends during the downturn, Giles Murphy and Peter Thorpe analyse the best ways firms have saved money and approaches going forward

The second quarter of 2008 was the first period for 16 years when the UK economy failed to grow. Since then, the onset of global recession has affected the vast majority of law firms, but the extent of that pain is only now being revealed as firms report their results for the last year.

The general trend so far seems to be that turnover is slightly up on the year prior but profit per equity partner (PEP) is significantly lower. However, there is, of course, no requirement for firms to report results (until they file their LLP accounts, which can be as late as next January). So, what about those firms which have remained quiet on their financial performance?

Given the climate over the last 12 months or so, is it a surprise that turnover increased? As most law firms have March or April year ends, the figures are probably buoyed by a relatively strong first half of the year, until the banking crisis hit hard in September and opportunities for legal work dried up.

The mix of a firm's practice areas is a key factor, with those exposed to transactional corporate work and real estate likely to be the worst affected. In terms of international firms, performance seems to be variable. Clearly the whole world is suffering, but UK firms with overseas offices have benefited from exchange gains, boosting income reported in sterling.

Perhaps the more important question is not what has happened historically, but as the economy struggles to recover, what will firms' performances look like in the next financial year? And what steps are they taking to improve it?

Predicting the future

By far the greatest difficulty facing law firm management in the current environment is how to budget in a period of massive uncertainty. Should firms simply wait for any upturn and accept significantly lower profits in the meantime, or do they cut costs and, if so, how deep? The response will impact directly on profitability and cash flows for years to come. As a result, the quality of leadership in today's law firms and the ability of those at the top to make decisions are absolutely critical.

So what should management be doing to overcome these difficulties? In terms of measuring profitability, lose the obsession with PEP. It is a misguided assessment of true financial performance and can be easily manipulated, for example, by excluding one-off costs and the subjective calculation of numbers of equity partners.
Instead, the use of margin analysis is a much more reliable measure of performance. Assumptions need to be made on how the existence of equity partners should be incorporated in the calculation, but with a growing number of firms reporting their results as LLPs on a consistent basis, comparison between firms is much more meaningful.

However, a key issue that has been highlighted by recent law firms' results is that profits appear to fall faster than income. As shown in the table, although income has fallen by 10% and costs by 5%, profits have plummeted 21.67%.

Of course, the reverse can happen, and many firms have benefited from such positive trends over the last few years. However, as income has risen, firms have also felt costs rise, with new premises and employees demanding an ever-increasing salary level.

In general, the greater flexibility and control that a firm has over its cost base, the quicker it will be able to react to maintain profitability. For most firms, the challenge is that costs such as personnel and property are difficult to cut in the short term without incurring what is considered to be substantial pain. Is it better to sit it out and hope for a recovery, or is that a sign of weak management?

Boosting cash flow

While profitability is a key measure of financial performance, cash is required to pay the bills. Understanding the difference between the two may sound obvious, but is often forgotten.

Each month, a firm pays its salary bill. During the month, work is done by employees and put on their timesheet. Possibly in the next month, an invoice will be raised and maybe in the next two or three months, the client will pay the invoice. In that time, the VAT element of the invoice may have been paid to HM Revenue & Customs and there might have been a rent bill to settle, all potentially leading to a substantial cash outflow before money comes in. In periods when there is less chargeable time, cash outflow may broadly remain the same, but cash inflow may be less and take longer. Moreover, a number of firms are now coming to the end of rent-free periods on new premises and at the end of July 2009, sizeable tax bills will need to be settled (resulting from record levels of profits earned in the 2008 accounting year).

The balancing item between all of these cash flows is partner drawings. However, these are now being squeezed and reduced in a significant number of firms. What's more, the increase in personal tax rates next April means that firms with April year ends are now earning profits that may well be taxed at more than 50%. This means they should be reserving for more tax, reducing the element left over for drawings even further.

In times of uncertain income levels, minimising the amount of cash required for working capital purposes is critical.

Assume that a firm with annual income of £12m has debtors and work-in-progress (the working capital or 'lock up' of the firm) of £5m. Its lock up expressed in days is around 150, which means that, on average, when work on a project starts on 1 January, the firm does not get paid until 1 June. The firm then sets an objective to improve lock up by 30 days – i.e. on average being paid by 1 May for the example. The effect of this relatively small change would be to increase cash in the firm's bank account by £1m.

Managing lock up is not just the role of the finance department. All fee earners should be responsible and appraised accordingly. It should be considered a serious offence if this is not given top priority in the current environment.

Cutting tax

Firms should also be reviewing their accounting year end. In times of increasing profits, a 30 April year end offers firms a cash flow advantage as tax payments in respect of those profits are payable significantly later than when they are earned. However, in times of decreasing profits, a firm might want to consider moving the year end to, say, 31 March. Depending on the level of falling profits (and the level of 'overlap relief'), there may be benefits to the firm. If nothing else, it will delay the impact of the increase in the top rate of income tax for a year.

Reducing costs

While many firms have undoubtedly taken the opportunity in the current economic climate to cut unnecessary expenditure, some firms have been innovative in dealing with their largest cost – salaries. Sabbaticals, reduced hours, retraining or transferring into other practice areas are ideas that are being implemented as an alternative to redundancies and as ways of maintaining the resource base for core work. Ultimately, for a number of firms, this has not been enough, and the news that a firm has made employees redundant or let partners go is no longer front-page news.

Firms should, as a minimum, be reviewing their discretionary spend and identifying those costs that they need to incur in order to achieve their business plans. 'Nice to have, but not essential' areas of expenditure such as marketing and training should be under scrutiny at all times of the economic cycle, but are under increasing risk of being cut in the present climate.

Some firms have adopted more radical approaches to cost reduction. For example, Pinsent Masons has outsourced certain litigation work to South Africa, estimating a 50% cost saving. Osborne Clark has launched an innovative outsourcing model and, in most firms, there are an increasing number of services, such as catering, being outsourced in the hope of improving the service but undoubtedly cutting costs.

If the threat to current performance from the economic environment was not enough, the introduction of the Legal Services Act will attract greater competition to a sector seen, historically, as highly profitable. The law firm of the future will have to be highly efficient and adaptable, well financed and well run – if, of course, it survives the current economic conditions.

Giles Murphy is a director and Peter Thorpe an associate director at Smith & Williamson.