Stable profit margins prove lawyers are learning to be flexible as incomes fall, says Grant Murgatroyd

There is no 'silver bullet' metric for measuring the strength and performance of law firms. But profit margins may be a better guide than much-maligned, though closely followed, profits per equity partner (PEP).

Average net profit margins at the top 50 firms by revenue – at least the ones that disclose full financial performance – have remained fairly stable over the past three years, rising from 25.8% in 2010-11 to 26.6% in 2011-12, before slipping back to 26.2% in 2012-13, according to Legal Week analysis.

The fact that margins have been stable in a volatile economic environment is a sign that law firms have become more flexible about managing their cost base to reflect falling income. 

"In the past, we have been critical of professional firms in that they are slow to react to changes in income levels," says Giles Murphy (pictured), head of professional practices at business advisory firm Smith & Williamson.

"This time around, you can say the real estate sector had to move fast when the recession hit, accountants moved quite fast because they understood the numbers, and lawyers are learning to move fast. It is fair to say that, five years on from Lehman, law firm managers are quicker at making decisions."

But are margins any better at showing how firms are performing? "The problem in law is that there isn't a silver bullet metric," says Tony Williams, former managing partner at Clifford Chance, now principal of consultancy Jomati. 

However, he concedes that PEP has been "widely discredited because people manipulate equity and non-equity numbers to get what they need", which means that profit margins may well be a more reliable indicator of overall fee earner performance. "You probably get a correlation between higher fees per fee earner and higher margins," Williams says.

A simple look at the magic circle shows the discrepancies on margins between firms with high PEP. Excluding Slaughter and May, which is estimated to have PEP of £1.8m for 2012-13 but does not reveal firm profitability, Freshfields Bruckhaus Deringer topped the rankings for both PEP (£1.4m) and profit margin (44.9%), while Linklaters was second (£1.3m and 43.7%). 

But comparative minnows Macfarlanes (43.1%) and Travers Smith (39.6%) both boasted higher net margins than Allen & Overy (A&O) and Clifford Chance, despite the latter pair coming third and forth respectively when ranked on PEP.

While PEP is criticised because it can be manipulated, net profit margins are by no means a perfect measure as firms with more salaried partners will show a lower net profit margin than those with more equity partners. And clearly the size of the equity rank needs to be taken into account.

However, Rowan Williams, the head of Baker Tilly's London and South professional practices group, insists that margins are a far better way of seeing how a firm is performing. "Many law firms focus on profit margins, but often not to the extent they should do," she says.

"Historically the main measure of success has been PEP, which is not the right indicator to focus on. PEP is very misleading as it is dependent entirely on the partner profile of a firm. If you look at profits overall and profit margin, it does not matter how you categorise your fee-earning partners."

Charles Martin, senior partner at Macfarlanes, agrees: "Profit margin is an important indicator because it is indicative of both revenue generation ability and management of the cost line. 

"It really represents a coming together of the client-facing aspects of the practice and the internal cost management side of things. Although we are happy to see the business growing, growth of itself is not an objective for us. We are interested in growth only if it is at the right profit margin."

RPC managing partner Jonathan Watmough adds: "Year-on-year comparisons of profit margins give a good idea of how businesses are trending. In most cases, a drop in margin might show that prices have either stayed steady or dropped back a bit, while salaries continue to trend upwards.

"Certain firms might have seen a drop in margin, for example, because they are chasing lower-quality work or have gone on a huge hiring spree, resulting in more costs."

Wim Dejonghe (pictured), A&O's managing partner, concludes: "Profit margins say a lot about how effectively management is running a firm. They are influenced by several factors, but I think the main influencers are cost base, leverage and pricing. 

"While profit margin is a key performance indicator in this regard, it does not give the whole story. The expense base is higher if there is a higher proportion of lawyers to equity partners, for example. It's all relative."