Looking at Firm Profitability and Productivity
A Practice Smart (TM) Feature
By Michael Blum
If you have a Balance Sheet and Income Statement for your law firm, then you have valuable information, which may provide you with insight into firm profitability and productivity. The information is accessible from Quickbooks or any basic accounting program or from your bookkeeper or accountant. The data can be easily accumulated and entered into a spreadsheet so that the data can be studied and trends easily followed.
Profitability metrics can be viewed in many ways – trends by year, current month versus same month in prior years and actual versus plan. But do not be fooled by the heady illusion of profitability if you are just signing up cases. If new cases are not consistent with your strategy, are not profitable (as opposed to providing you with revenue or profit), or are not sustainable, then you have a serious and growing problem. Remember, you can sign up cases that are not profitable, even if you recover.
With a contingency fee law firm in mind, let’s examine some building blocks needed to develop the metrics to look at profitability and productivity.
1. WHAT ARE YOUR ASSETS?
Yes, we all know that assets are the things that a business owns like equipment, furniture and real estate. But don’t forget the potential fees embedded in your portfolio of contingency fee cases. These should make up the great majority of your assets.
To get a true idea of the value of your cases and your assets, you must honestly estimate the value of your cases and the fees you will potentially generate on a regular basis. More than one firm (large and small) has found that they have estimated the value of a case, class action or mass tort only to be “shocked” when the case settled or a verdict was much less than they anticipated. (see “6 Financial Hazards Every Contingency Fee Firms Should Know” Blog, AppealFundingPartners.com.)
2. WHAT ARE YOUR LIABILITIES?
It is easy enough to create a list of monthly costs broken down into several categories. Compensation (salaries, draws, payroll taxes) GA (rent, office supplies, etc.), loans (principal and interest), equipment lease payments, marketing expenses, and litigation costs. This information can be found in your income statement and in your cash flow projections.
3. GROSS PROFIT
Gross Profit is a firm’s residual profit after collecting its revenue and deducting litigation expenses. In the case of a contingency fee law firm, it would be the litigation expenses, which exclude expenses that are directly involved in the day to day operation of the firm (operational expenses).
- Gross Profit = Revenue – Litigation Expenses
Assume Revenue is $2,000,000 and litigation expenses are $500,000. The Gross profit is $1.5 Million.
When analyzing a company, gross profit is very important because it indicates how efficiently management uses the costs for litigating cases.
4. WHAT’S YOUR GROSS PROFIT MARGIN?
Gross Profit Margin
Gross margin is a good indication of how profitable a firm is at the most fundamental level. It reflects how efficiently a company uses its resources.
Your gross profit margin is calculated by dividing your gross profit by your total revenue.
- Gross Margin = Gross Profit / Revenue.
If the Gross Profit is $1.5 Million and Revenue is $2,000,000 the Gross Margin is $1,500,000/$2,000,000 or .75 x 100 = 75%
The higher the percentage, the more the firm retains on each dollar of revenue to service its other costs and obligations. Being able to track a declining gross profit margin can give you a heads-up that you must increase your revenue or reduce your costs. If your gross profit margin is staying consistent or trending upward, you are probably on track in terms of your ability to pay for the services you provide. In the worst cases, of course, your gross profit and your profit margin disappear altogether. At that point, you’ll be like the fellow who lost money on every sale, but figured he could make it up in volume.
5. NET PROFIT
Often referred to as the bottom line, net profit is calculated by subtracting a company’s total expenses from total revenue, thus showing what the company has earned (or lost) in a given period of time (usually one year).
- Net Profit = Revenue – (Litigation Expenses + Operational Expense [including taxes, interest and depreciation])
6. WHAT IS YOUR NET PROFIT MARGIN?
The net profit margin (aka return on revenue) is a ratio of profitability calculated by dividing revenue into net income. This ratio shows the amount of each dollar of revenue that is left over after all expenses have been paid.
- Net Profit Margin = net profit/revenue
If a decrease is observed in this ratio, the firm should know that the expenses are not being managed as efficiently as in the past or revenue is declining. It should find why and take steps to reduce expenses. An increase in this ratio may be an indication that the expenses are being facilitated efficiently and revenue is increasing.
This ratio indicates the financial performance of the firm and does not reflect anything about the financial position of the firm because it does not take into account the assets and liabilities.
7. WHAT IS YOUR DEBT RATIO?
The debt ratio indicates the proportion of a firm’s debt to its total assets. It shows how much the firm relies on debt to finance assets. The debt ratio gives a firm a quick measure of the amount of debt that it has on its balance shows compared to its assets. The higher the ratio, the greater the risk associated with the firm’s operation. It is an indication that the firm is being financed by creditors rather than from its own financial sources, and may indicate a dangerous trend. Lenders usually prefer low ratios because the interests are better protected in the event of a business decline. A low debt ratio indicates conservative financing and the potential to attract lending capital.
- Debt Ratio = Total Liabilities/Assets
Assume debt is $300,000 and Assets are 3,500,000. The Debt Ratio is $300,000/$3,500,000 = .086 x 100 = 8.6%
Having this ratio climb can be a bad sign — it might reflect a major expansion and the conscious assumption of debt, but it can also indicate that you’re getting in or have gotten in over your head.
8. WHAT’S HAPPENING WITH YOUR INVENTORY OF CASES
Being able to track how long it takes for your cases to be resolved may tell you whether business is increasing or slowing down. It also tells you how long money is tied up in a case which might be used for other cases or investments. This calculation should be applied to individual cases as well as, types of matters (product liability, med mal, etc.) and your portfolio as a whole.
- Days to Resolution = total number of days to resolve X number of cases/ X number cases.
9. RETURN ON INVESTMENT (ROI)
ROI is a powerful tool, and measuring ROI for cases, as well as annually for the firm is well worth the effort. It is a performance measure used to evaluate the efficiency and consequences of an investment in a case and in your portfolio of cases.
ROI will help you determine the positive or negative contributions of cases, or types of matters to the revenue cycle and, ultimately to the bottom line. Armed with this information, you can discover the profitability of your firm as well as help your firm identify types of matters that are more profitable than others.
If an investment has a positive ROI and there are no other opportunities with a higher ROI, then one should consider making the investment. A higher ROI means that investment gains compare favorably to investment costs.
- ROI = the returns of an investment (case, matters, firm) divided by the costs associated with the investment(s).
Typically omitted from these costs is the cost of labor (attorney time) which it may turn out to be a critical factor in calculating the ROI. Although not often done by contingency fee law firms, and there are many excuses used not to track time, there are numerous reasons why plaintiffs’ attorneys should track time.
By using billing programs you will know exactly how many hours were put into a specific case and you can calculate the hourly rate to include in the cost of litigation and in your analysis of the profit and profitability.
Furthermore, the information can be used as a very important element of any motion for attorney fees in a claim for Quantum Meruit, and certainly is compelling evidence as part of certain malpractice defenses or if the court must approve a fee for an infant’s compromise or wrongful death case.
- ROI = (gains from the investment – costs of the investment)/ Costs of the investment.
In addition to past performance, ROI can also be used to forecast returns on future activities, which might help to determine whether to take a case or not. One drawback of ROI is that by itself, it does not say anything about the risks associated with an investment (case). ROI just shows how a return compares to costs. Therefore a good case analysis should also consider both the ROI magnitude and the risks that are associated with the case.
What is an acceptable ROI —10, 20, 50 percent? The main purpose of the measurement is to interpret the result relative to the ROI of other cases or even investment opportunities outside the firm.
For example, if you determined that the ROI from med mal cases is 35 percent and that the ROI from slip and fall cases is 2 percent, you might want to consider focusing your future time and resources on med mal cases.
Benchmarking is another use of ROI. If the med mal cases yielded 35 percent in year one, your minimum expectation in year two should be 35 percent or higher. If you have no basis for comparison, you are left to judge each set of results on its own merits.
There are numerous metrics which can be generated from financial statements. Some indicate financial performance, others indicate financial position Metrics used correctly are very useful tools in managing your firm, but they must be subject to good judgment and the flexibility to make good legal and business decisions. The metrics discussed are meant to stimulate thinking about the business of law and to motivate business of law discussions with your partners, accountants and advisors in light of your unique practice and situation.
Michael Blum is a trial attorney and CEO of Appeal Funding Partners, LLC with over 20 years experience providing risk mitigation services and non-recourse funding to attorneys and plaintiffs with money judgments on appeal. He has served on the Board of Directors of the Consumer Attorneys of California and of the Marin Trial Lawyers Association and regularly speaks to trial-lawyer groups and has written for TLA magazines on the financial management of a contingency-fee law firm. He may be contacted at 415-729-4214 or firstname.lastname@example.org. Visit www.appealfundingpartners.com
Practice Smart(TM) Features are a service of Michael Blum and Appeal Funding Partners, LLC. The Features are thoughts from a variety of sources on our practices, on being trial lawyers and things of importance to trial lawyers and their clients.
This article is provided for informational purposes only and with the understanding that the author is not engaged in rendering legal, accounting, tax or other professional advice or services. The discussion is not intended be relied on for any purpose; seek the services of a qualified professional.
© copyright 2013 Michael Blum
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