The importance of cash flow forecasts and projections for law firms
Rosy Rourke of Armstrong Watson presents a guide to accurate cash flow forecasting and projections for firms of all sizes, and explains why they are a somewhat overlooked business planning tool.
I’m going to start with an age-old cliché: ‘Turnover is vanity, profit is sanity, but cash is reality.’ It remains more relevant than ever. The ability of a law firm to access cash will secure its financial health and allow it to survive and grow.
Financial and cash flow forecasts and projections can be prepared by a law firm for specific reasons, for example:
- raising finance
- Lexcel purposes
- applications to the SRA on changes to their structure.
But they can and should also be used as a proactive business planning and control tool for setting targets and improving performance within your firm.
Although cash is the reality, a law firm also needs to understand on an ongoing basis what it expects to achieve in terms of turnover and profit, as they both have an impact on the future decisions you take.
Many firms ask us how far ahead they should prepare their cash flow forecasts and projections. We always recommend that all firms, whatever their size, should be forecasting for at least 12 months ahead. This lets you assess any serious cash flow and financial stability issues, provides an indication of likely performance, and allows you to make any necessary future investment and management decisions.
Alongside these 12-month forecasts, you should prepare a 13-week rolling cash flow forecast, to highlight any short-term cash pinch points. These must be addressed immediately.
Cash flow issues
Cash flow problems can affect law firms of all sizes, even the most successful and profitable firms. Although forecasting will not in itself resolve these issues, identifying potential pinch points in advance gives you a chance to mitigate any cash shortages. They also allow your firm to manage its fee-earners to help them achieve their fee income targets within your forecasts.
The main root of cash flow issues in law firms is the amount of cash that is tied up in lock-up (unpaid bills and work in progress (WIP)). Our legal sector benchmarking report found that the current average number of lock-up days for law firms of all sizes is 155. This number has increased for many firms in recent years, particularly those that fail to forecast and plan thoroughly.
Once you begin forecasting, you’ll note that many of your firm’s necessary expenses are fixed, or certainly predictable (staff salaries, rent, subscriptions etc). Costs and expenses are, of course, vital to accurate projections and cash flow, and readily identifiable from your recent financial results. Ensuring your firm is as lean and efficient as possible by tightly controlling costs is essential; you can make many savings on these fixed costs simply by changing suppliers. Analysing your costs for your projections can help you focus on this.
Bend and flex
What is not as certain, but will drive and impact your cash flow forecast and projections more than anything else, is accurately predicting your income and cash collection profile.
Detailed forecasting models use your firm’s historical data to project your fee income. This data should include utilisation and recovery rates by individual fee-earner, taking into account seasonality, debtor days and WIP days by work type and department. This detailed approach lets you project your firm’s likely cash inflows and future financial performance based on known data.
This approach also allows for sensitivity analysis to be built into your forecasts, to demonstrate the impact on the practice of best-case and worst-case scenarios, as well as highlighting what you need to achieve to ensure you have enough cash to continue as a business. This work is an invaluable planning tool for your business and lets you make timely and effective strategic decisions.
Comparing your actual results against your projections, and monitoring this on an ongoing basis, gives you valuable insight into your business and helps you make the right ongoing decisions to keep things on track.
The ability to flex your projections can also help you focus on what you need to do to achieve your firm’s targets in the coming years. Your projections can be used too as a management tool, by closely linking them with managing performance. The sensitivity analysis can be used to set utilisation and recovery targets for your people. These should be based on what you need your people to achieve in order to meet your firm’s projected performance.
Preparing accurate projections will help you keep track of expected future profits and the impact that will have on your business and cash flow, either positive or negative.
The most likely pinch points for cash in a law firm are when salaries, VAT and personal and corporation tax liabilities fall due. Salary and VAT liabilities are relatively easy to assess and forecast, but corporation tax and in particular, personal income tax liabilities, are more difficult to handle, and can have a material impact on your cash flow if not suitably planned for.
Accurate future forecasting will allow for tax payment planning for the business as a whole, including the income tax liabilities of individual partners, which will need to be paid by the practice. These can be tracked and monitored on a monthly basis. The impact on future tax payments is particularly important in partnership businesses in managing payments on account. Where profits are falling, cash flow can be actively managed by reducing those payments in a timely manner.
Similarly, for larger firms which must pay their corporation tax in instalments, accurate forecasts for the year ahead will ensure accurate payments are made matching profitability and cash flow.
Although not strictly related to forecasting and projections, you should encourage your partners to complete their personal tax returns as soon as possible after the end of the tax year, to give you maximum notice for any unexpected changes to tax liabilities. These changes can then be incorporated into your forecasts and projections, and thought can be given to relevant funding and how that can be accessed, if need be.
Another vital factor to consider in your forecasts and projections is the capital needs of your partners. Accurate cash flow forecasting will help you set drawings levels for the next year, and also allow you to plan for when partners retire and the subsequent repayment of their capital accounts.
Detailed, accurate projections will allow individual needs to be balanced against overall business needs.
Clearly, there are many different factors to consider when preparing cash flow forecasts and projections. It may seem daunting, particularly for smaller firms which don’t have necessarily the time and resources to spend on business planning. However, if your firm does not know what is ahead, it is unlikely to fulfil its potential, and may fail due to that lack of foresight. Financial projections, however detailed, can help to mitigate that risk.
Rosy Rourke is a legal sector director at top 30 UK accounting firm, Armstrong Watson LLP. Rosy works exclusively in the legal sector advising law firms throughout the UK on strategic, structural and other business improvement issues as well as providing efficient accounting, tax and SRA accounts rules services. Further information can be found at www.armstrongwatson.co.uk/legalsector
This article is a general guide to the issues that we see in practice. It is not a substitute for professional advice which takes account of your personal circumstances. No responsibility can be accepted for any loss occasioned by any person acting or refraining from action on the basis of this article.
The Law Society has partnered with Armstrong Watson LLP for the provision of accountancy services to law firms throughout the whole of the north of England.