Is your firm really financially stable?
The SRA is probably right to be concerned about the financial stability of many law firms. If a firm collapses, this is likely to be painful for everyone in the firm but it is also difficult for clients and it does nothing to enhance the good reputation of the legal profession. The SRA’s own analysis indicates that about a third of potential problems in firms are due to concerns over their financial stability. Given the state of the economy, there is little sign of significant improvements to the financial health of firms in the foreseeable future.
A problem for a firm typically crystallises with the inability to pay a large expense such as monthly salaries, rent or tax bills. At this point it may be very difficult to find an answer and so it is important that firms try to avoid getting anywhere close to this position.
So what are the common indicators of a possible problem?
Signs of a forthcoming financial problem would include:-
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- Drawings exceeding net profits
- Increasing reliance on bank borrowing and overdrafts
- No retention of profits
- Need to borrow to pay PI, partner tax and VAT
- Not all partners aware of the cash position of the firm
- Poor, late or incorrect management information
- Loss of key clients
- Loss of key people
Finances tend to deteriorate slowly before finally the problem crystallises. It is therefore vital to monitor things regularly so that action can be taken sooner rather than later. The COFA at a firm is responsible for ensuring that such management is being undertaken.
What needs to be done to ensure that possible problems are dealt with promptly?
Every firm is different and therefore the required actions will vary considerably from firm to firm. Some of the issues which should be addressed include:-
1. Quality of budgets and management information
Have budgets been agreed and accepted by everyone or have they just been imposed by management? Is it understood who is responsible for the delivery of these budgets? Is management information produced regularly and accurately and made available to the right people. Does this information focus on profitability as well as lock-up? Are regular meetings taking place where this information is being reviewed and necessary actions agreed? Have people been trained to read and interpret the information?
2. Cash flow forecasts
Is a detailed cash flow forecast being prepared every month for the next six months to identify possible cash shortages? Who reviews this document and takes the necessary decisions so that a cash crisis is always avoided?
3. Adequacy of capital
Does the partnership agreement need to be reviewed so that capital is more easily retained? How quickly can retiring partners extract capital and how quickly must new partners contribute capital? How quickly are profits to be distributed? How much of the profit is to be retained to finance growth and how is this done in a tax efficient way?
4. Review of bank facilities
How much should the firm be happy to borrow and when would borrowing be seen as excessive? Should the level of borrowing which a firm makes be linked to capital or annual fees? Is there an appropriate mix of term loans and an overdraft facility or is there too much reliance on overdraft.
5. Cheque signatories
Should one partner be able to sign cheques without limit or should cheques over a certain amount always require two signatories? When times are desperate a partner might revert to desperate measures.
Financial education may be important, not just for the COFA but for anyone else with responsibility for budgets. Behaviours need to change so that the firm will be more tightly managed. Telling people what to do is not necessarily as effective as explaining why things need to be done in a different way.
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