How to improve your financial management

Effective financial management is typically all about constant focus and incremental change. Throughout this year’s The Lawyer UK 200: Financial Management report you will find ­numerous examples of where and how firms have achieved changes to debt levels or lock-up (the ­combination of work-in-progress (WIP) and debtor days). Even though on the face of it these changes may look slight, ultimately they can have a very significant impact.

As DAC Beachcroft managing partner David Pollitt put it in last year’s report: “Every day we reduce lock-up is worth half a million in the bank to us. Improve lock-up by 10 days and we have an extra £5m in the bank.”

That’s quite an incentive to get those bills out and collect the cash. But the impact of changes to WIP, debtors or levels of borrowings and the reasons behind them are not always straightforward. Unlike some of the metrics in the main UK 200 Top 100 ranking, most notably total revenue and average profit per equity partner (PEP), where bigger is usually better, many of the indicators in this report are less obvious in terms of what they reveal about a firm’s overall financial health. They can also fluctuate significantly year on year, buffeted and influenced by a wide range of factors but not necessarily representing a red flag.

In other words, rising debt is not always bad; lengthening lock-up not always a sign of poor financial management. It is a good idea to be wary of making a snap value judgement about the significance of a change in either debt levels or lock-up. Very often there are very sound reasons behind the changes.

Behind the headline figures

Take Penningtons Manches. Last year the firm’s year-end debt level rose by 55 per cent while total lock-up, specifically the work-in-progress (WIP) component, also rose. This appears to be in sharp contrast with comments made by the firm in last year’s The Lawyer UK 200: Financial Management report when the firm said it was aiming to reduce its then £10m borrowings over the next three years.

At first glance the increase in both metrics would seem to indicate financial management issues or cashflow-related ­problems. Not so, says the firm’s CEO David Raine.

“You’re looking at the year-end in April as a single point in the year but at the year-end we have to make a quarterly payment for VAT, rent, salaries etc” David Raine

“You’re looking at the year-end in April as just a single point in the year but as of today our total borrowings are less than £8m,” says Raine. “At the year-end we have to make a quarterly payment for VAT, rent, salaries and so on while last year the major expenditure was on our two biggest offices, London and Guildford.”

Clearly this has a significant distorting impact on the true level of firm-wide debt. Raine’s comments also highlight one of firms’ biggest costs and, as The Lawyer UK 200: Workspace Trends report revealed in September, potential differentiating factors. In respect to the latter, an increasing number of firms are now recognising the benefits of investing significant sums into their real estate.

Last year Penningtons consolidated its two offices in ­Godalming and Guildford into one larger office at 31 Chertsey Street, while in London it invested in a fit-out of its office at
125 Wood St. The latter is now its sole home in the capital when at one point, post the merger with Manches, it had three.

“Everyone is now here in the one building on five floors,” adds Raine. “It is a major upgrade on where we were. We wanted to make a statement. We’ve borrowed £2m for the fit-out and tech upgrade of London, which is on a 10-year lease, while in Guildford we’ve spent around £600,000. We’ve put it all on a £2.5m, five-year loan.”

The firm has also invested the best part of £1m to get all of its technology infrastructure moved across to the Peppermint platform over the next 12 months.

“We’ve invested in our knowledge team and will be getting people to engage with the technology,” adds Raine. “We believe that this in itself breeds efficiency.”

Office investments

Similarly Mishcon de Reya’s debt level rose last year but like Penningtons, the firm has a very specific reason for this increase, as the firm’s finance director Mayank Patel, explains.

“The significant loan we have was taken solely to fund the fit-out of Africa House,” says Patel of the firm’s London office to which it moved last year.

“The bank loan for the fit-out of Africa House is a five-year revolving credit facility. We have already made significant repayments against that loan facility and continue to plan to make further significant repayments.
“As we make these repayments, the original facility remains available to us to draw down against if we so wish but have ­decided to permanently reduce the level of the facility as we make repayments.”

As Patel adds, when it comes to lock-up at Mishcon, “We focus on education”. Patel says Mishcon “very closely” monitors cash collection against its daily cash collection target along with debt levels, write-offs, and provisions, adding, “we continuously train all fee-earners about our credit management policies and processes”. (For more detail about Penningtons, Mishcon and all of the dozen firms profiled in our Financial Management Firm by Firm section in the main report.)

Patel’s comments reinforce the impression of a tightly run firm. Nevertheless, the impact these apparent marginal ­changes are capable of having on a firm that has less of a focus on ­financial management is considerable.

Beware false trails

The results from the UK 200 firms for this year’s Financial Management report underline the difficulties in making any general statements about the performance of this group solely based on the data. This is particularly shown in three charts in the main report which show the distribution of ­percentage change in annual WIP, debtor days and lock-up.

It is striking that all three charts show that around 50 per cent of firms report a reduction in these metrics, ie the financial management apparently improved, but also in all three around 40 per cent of firms saw the metrics lengthen, or deteriorate.

In short, there is no trend here as obvious as might be seen with generally rising or falling profits or turnover across the ­majority of firms in the UK 200: Top 100 report. And as ­illustrated above, a lengthening lock-up or increasing debt should not necessarily automatically ring warning bells.

Part of the reason for that is the variety of firms and practice types in the UK 200. The data also highlights the multitude of factors that play a part both in firms’ approach to efficient financial management and in their lenders’ sentiment towards providing debt facilities as and when required.

“Lock-up can be a key barometer and an indicator of ­operational health, but it needs to be set against the firm’s strategy and where they are in their cycle” Simon Adcock

“Lock-up is a key barometer and indicator of operational health,” confirms HSBC’s head of professional services Simon Adcock, “but it needs to be viewed against the firm’s business mix; factors such as practice groups, sectors, size of clients and jurisdictions have an influence.

“If firms are targeting partners on cash collections, then it’s also important to track the discounts to ensure they aren’t ­foregoing revenue for easy settlement.”

In other words, a start-up will generally be burning cash and unlikely to be profitable whereas a larger firm that last upgraded its practice management system a decade ago is more likely to have a need to borrow funds, says Adcock.

“We look at trends year on year, movements in the top and bottom line, and costs all over the medium term,” says Adcock. “You can’t really look at firms in a one-year snapshot and do a comparison. Firms will also display different financial dynamics ­depending on their investment cycle; a firm that is investing now is likely to carry more debt than one that upgraded its practice management system three years ago.”

Adcock also says that given the current trend for investing in technology and platforms, HSBC is seeing a greater appetite for firms to finance projects with bank debt repayable over five years as this can moderate the cashflow impact on partner’s distributions.

“Debt is relatively cheap by historic levels and financing can enable a quick deployment of a material project, maintaining a firm’s competitive advantage,” says Adcock.

This said, there does appear to be a clearer trend this year in relation to total year-end lock-up targets. Coupled with the 53 per cent of firms that report an improvement in lock-up, it does suggest that UK firms are becoming more efficient.

In 2013 just 37 per cent of firms either achieved or bettered their lock-up target at year end. This year that figure had risen to 52 per cent.

There is, however, a notable contrast with the average lock-up position, where only 35 per cent of firms achieved their target.