Law firm finance – The cash gap
13 Apr 2020
Any business requires a steady flow of cash in order to continue functioning successfully. This applies equally to companies both large and small, cutting across all industries including law firms. While this basic principle may seem self-evident, it was one of the main reasons for the dot com crash in the 1990’s and remains a catalyst for why many small businesses get into trouble.
Cash flow is not the same thing as revenue or even profits. While the latter provide an accounting view of the profitability of a law firm, only cash flow tells you how much money is in the bank at the end of each month. As the old saying goes – revenue is vanity, profit is sanity, but cash is king.
The Law Firm Cash Gap
Legal practices generate profits by charging clients fees for legal services rendered. While cash moves in and out of a law firm, the difference in timing between when you pay your expenses and when clients eventually pay you, can be significant. Cash inflow from a law firm’s clients always seems to play catch-up with the cash outflow of business operations. In fact, firms often pay wages and other expenses before the invoices have even been sent. Any disruption in the smooth payment process puts a lot of pressure on this tenuous system.
The Cash Gap in a legal practice is defined as the difference in time from when salaries and other overheads are paid for legal work and the settling of an invoice by the client. Well-run firms constantly work to shorten the cash gap as far as possible to reduce the cash strain.
Only by having a defined measure of a law firm’s cash gap, can the managing partner successfully manage the liquidity of the firm. As management guru Peter Drucker says: “you can’t manage what you can’t measure”.
CASH GAP: The difference in time from when salaries and other overheads are paid for legal work and the settling of an invoice by the client.
Historically, the cash gap for law firms is approximately 105 days. Clients typically settle their accounts in 60 – 90 days, while overheads are paid within 30 days (see figure 1.1). However, this can be much larger depending on the areas of law practiced by the firm. For example, an attorney who litigates personal injury claims on a contingency basis may need to carry the cost of overheads and disbursements (advocate fees, medical expert reports, actuarial loss of income reports, etc) for many months or even years before receiving payment from the Road Accident Fund.
Fig. 1.1 Cash flow timeline for a law firm
Funding the Cash Gap
Working capital is money available to a law firm for day-to-day operations. Simply put, working capital is an indicator of a firm’s liquidity, efficiency, and overall health.
When financing working capital, it is important to consider both the sufficiency and suitability of funds. While the managing partners of most firms constantly focus on sourcing enough capital to meet the day-to-day demands of the business, not enough attention is paid to the suitability of those funds.
The suitability of funding should be assessed across four dimensions:
- Source – Should the firm raise capital from its directors/partners, family and friends, a traditional bank loan or a specialist lender? Each has a unique set of characteristics that will impact whether they are the right fit for the firm and its partners.
- Cost – Various financing structures can have tax advantages so the after-tax cost of funding is most important to consider.
- Term – A firm’s financing term should, at minimum, match the length of the cash gap in order to avoid the risk of failing to repay the finance supplied.
- Structure – Debt and equity capital comes in many forms. A funding structure which is tailored to your requirements, such as an interest-only initial period, can alleviate pressure and better match the requirements of your firm.
Law firms, like many businesses, face the continuous challenge of funding their working-capital requirements. Measuring the cash gap allows partners to manage the health of the firm’s cash position. Financing working-capital is not as simple as raising cash from the cheapest source available but should be assessed across the multiple dimensions of risk and reward.
Disclaimer: This article is for educational purposes only and should not be misconstrued as financial or tax advice. Consult an accountant or registered tax practitioner for advice specific to your financial situation.
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