Sme legal practices survey 2014

2014 SME Legal Practices Survey

@HWFisherUK

www.hwfisher.co.uk2 | SME Legal Practices Survey 2014

Introduction and methodology Impact of legislationBusiness operations, fees and staffService lines and Mergers & AcquisitionsFinancial statisticsAnalysisConclusionSummary

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HW Fisher & Company’s Professional Practices Group advises solicitors, surveyors, patent agents, architects and other professional businesses on a wide range of financial, structural and operational issues.

www.hwfisher.co.uk SME Legal Practices Survey 2014 | 3

Introduction and methodology

The small and medium enterprise (SME) legal sector continues to face a number of pressures, despite the improving economy. The Legal Services Act (LSA) may have finally begun to sink in but new legislation, such as the Jackson Reforms and the banning of personal injury referral fees, has added another layer of complexity to the legal market.

At the same time, there is continuing downward pressure on fees (including an increasing number of fixed-fee and contingent fee arrangement structures) as well as firms facing challenges around recruiting and retaining the best talent.

This is the fourth benchmarking survey carried out by HW Fisher & Company among SME law firms in London and the South East. It aims to identify the main commercial and business development issues affecting those firms, as well as analysing how they are doing against their competitors in terms of key financial ratios around remuneration, turnover and profitability.

This year we asked SME firms about their views on the impact of the LSA and other new legislation; the growth of alternative fee arrangements; business processes and outsourcing; staff numbers and the growth of non-lawyer partners and salaried members; their partner charging rates and hours worked; and their plans with regard to potential growth through mergers and acquisitions.

Some of our key findings were that property and corporate activity are on the rise, replacing the more recession-friendly litigation work and highlighting that the UK economy is on the mend. However, many firms have also lost business in the wake of the Jackson Reforms and referral fees ban.

We also found that some of the firms are struggling to find enough top talent, leading to chargeable client work being outsourced or lost. Nonetheless, one of the major trends in limited liability partnerships (LLPs) staffing is the growth of salaried members and increasing interest in understanding the new HMRC tax regime faced by those employees.

In addition, the financial data on those firms, obtained from publicly available information at Companies House, highlights some of the key financial issues affecting the SME legal sector.

Methodology

The financial information was obtained at Companies House (as LLPs have to file their accounts there publicly whereas unlimited partnerships can still remain private). The other main research was carried out by telephone with a sample of LLP legal practices in London and the South East of England with turnovers between £5 million and £35 million.

To ensure consistency, only those LLPs with three-year histories have been included in the table of financial statistics on page 11.

HW Fisher & Company’s Professional Practices Group advises solicitors, surveyors, patent agents, architects and other professional businesses on a wide range of financial, structural and operational issues.

Contact us

For more information about our services to the Professional Practices sector or for further details on our annual survey, please contact

Paul Beber E [email protected] T 020 7380 4961

Jamie MorrisonE [email protected] 020 7874 7983

Nauzer Siganporia E [email protected] 020 7380 4965

David BregerE [email protected] 020 7380 4943


Impact of legislation

LSA

Now that the Legal Services Act 2007 (LSA) has been entrenched for several years, its impact is becoming clearer.

Last year, our research found that 93% of SME legal firms had not noticed any effect on their business from the LSA. In this year’s survey, this figure has dropped to around three-quarters (73%), but concerns that firms would lose out seem to have been allayed - in fact, the remaining 27% have claimed to have gained business thanks to the Act, up from only 7% last year.

This positive attitude continues when looking forward: 45% of firms now believe they will gain business over the next 12 months due to the LSA, up from 14% last year. Furthermore, whereas 36% believed in 2013 they would lose business over the coming year, now none do.

More topical considerations for the SME legal sector are the Jackson Reforms and the banning of personal injury referral fees. Although 72% of the firms we spoke with say they have not been affected, the remaining quarter or so have all lost business. This is unsurprising, and as the proposals slowly sink in we may see more firms being adversely affected.

Auto-enrolment

The research also asked law firms if they had agreed their staging date for workplace pension auto-enrolment with HMRC - a piece of new legislation affecting all employers in the UK. Around 64% have done so and 18% have not, although the latter figure is probably slanted towards the smaller pratices that don’t have to set up until 2015.

Perhaps of more concern was the 18% of respondants who did not know if their firms had agreed their staging date or not. It is an area that business leaders should certainly be familiar with and professional advice is vital.

Employing salaried members

Highlighting how the sector’s pay and partnership structures are shifting, this year’s research found that every single firm surveyed had one or more fixed profit share/salaried partners (‘salaried members’).

However, more surprising was the fact that only 36% of firms used Schedule D fixed profit share for those partners, while 27% instead used PAYE (and 36% had salaried members on both). PAYE can lead to an awkward mind set among partners if they see themselves as employees rather than equity contributors, and more importantly the tax advantages of Schedule D are considerable.

LLP legal practices need to be more aware than ever of this issue, as the tax rules for their salaried members have recently changed: HMRC perceives that there is tax avoidance in this area where it believes that individuals participate in the business as employees rather than as members of an LLP.

...45% of firms now believe they will gain business over the next 12 months due to the LSA...

...whereas 36% believed in 2013 they would lose business over the coming year, now none do.

72% of the firms we spoke with say they have not been effected...

...every single firm surveyed had one or more fixed profit share/salaried partners...

Thankfully, it appears that nine out of ten (91%) of firms have sought professional advice on these new rules and a similar percentage have been made aware of the potential impact of their firm’s cash flow.

It will be no surprise if HMRC starts going after LLPs once the new regime is bedded down, so firms that haven’t done so yet should be seeking professional tax guidance now.


...nine out of ten (91%) of firms have sought professional advice on these new rules...


Business operations, fees and staff

Last year’s survey saw an increase in outsourcing non-core business processes: six out of ten SME legal firms had outsourced some or part of their IT operations and around half had bought in external support to manage their human resources and payroll.

This year, some of the outsourcing was less evident, as only 27% of the firms surveyed outsourced IT and 36% looked externally for human resources and payroll. The big change, however, was that around one in ten (9%) now outsource chargeable client work, up from none at all in 2013. As the UK comes out of recession, there seems to be a shortage of talent that is forcing firms to look elsewhere to manage their core business as well.

Another positive economic sign is the growth in marketing/business development budgets. More than half (55%) of legal practices are spending more than they did last year - and none are spending less.

Fees

The average hourly rates for client partners and the number of hours they charge continue to provide some interesting insights into SME law firm efficiency.

Our 2013 research found that in half of the firms surveyed the average hourly rate for client partners was in the band of £251 to £350, and that the average rate across the sector as a whole was around £350 per hour. This year’s figures are much the same.

Last year, the average number of hours charged by partners per annum was around 1,100 and this was again the same in 2014. But this year, the research only found that 9% of firms had partners averaging less than 950 chargeable hours a year (down from 25%).

With fees uppermost in the minds of legal practices and clients alike, both are continuously moving towards a fixed-fee model. The survey highlighted that two-thirds of firms (67%) have seen a further increase in the amount of fixed-fee work they’ve done over the past year - a quarter have seen it jump by more than 10% - and none whatsoever have seen it fall.

According to the research, the average fee structure for SME legal firms is now 65% hourly/time-based, 30% fixed-fee and only 5% by results. This is a slight change from last year but can be attributed to a different survey sample. Nonetheless, the legal market clearly remains price-competitive.

In addition, ‘no win, no fee’ is on the rise: nearly half (46%) of the firms surveyed now use Contingent Fee Arrangements (CFAs) and a further 9% are planning to adopt them. But interestingly, 40% of the firms that use CFAs don’t track what percentage of each award actually goes to the claimant.

As the UK comes out of recession, there seems to be a shortage of talent that is forcing firms to look elsewhere...

Nonetheless, the legal market clearly remains increasingly price-competitive.


Around a third of firms (36%) have seen more downward pressure on fees over the past 12 months and only one in ten (9%) has seen less. But with more focus on fees than ever, it’s odd that almost two-thirds (64%) of legal firms have a recovery rate of 80% or better. This suggests that the pressure is combined with the legal sector’s legacy of only booking time they actually think is recoverable.

Staff

Staff numbers remain a useful barometer of the health of the SME legal sector and, same as last year, nine out of ten firms are planning to recruit more fee-earners over the next 12 months. In fact, more than 55% are looking to bring in both partners and solicitors.

Meanwhile, the use of unqualified fee-earners is rising further still as the economy strengthens. Almost half (45%) of practices have seen the number they employ jump over the past 12 months, up from a third (33%) in 2013.

...over the next 12 months...more than 55% are looking to bring in both partners and solicitors.

Service lines

With most of the evidence pointing to an economic recovery in the UK and the ban on personal injury (PI) referral fees, it comes as no surprise that SME law firms have seen a significant shift in their revenue streams over the past 12 months.

Corporate activity has increased slightly, accounting for 15% of activity this year as against 13% in 2013, but the big winner in recent months has undoubtedly been the property sector. Whereas in 2012’s survey it averaged 23% of all legal work before plummeting to 14% last year, this year saw it jump back to 26%.

At the same time litigation work, which usually sees an increase in times of recession, has fallen away. It accounted for an average of 36% of legal firms’ activity last year but dropped to only 26% of their work this year. But perhaps most markedly, the referral fees ban has seemingly had a huge effect on the amount of PI/negligence work being done by non-speciality firms, falling from 15% last year to just 1% in this year’s research.

In addition, probate wills and trusts is evidently a growth sector as it occupied only 4% of the SME legal sector’s work last year but has since jumped to 9%. There was also an increase in employment work, another positive sign for the economy, from only 5% in 2013 to 12% this year.

Looking forward to the coming year, nine out of ten firms (91%) now see property as a sector with growth potential and 82% feel the same about corporate work. This bullish attitude was markedly absent last year, when two-thirds of the firms surveyed saw recession-friendly litigation as the big opportunity.

Not only that, but around one in five (18%) firms say that they have done work in the past year that was previously carried out by their barrister associates. although down slightly from last year’s 26%, it still highlights this as another growth area for SME legal practices and a continuing concern for the barrister profession.

Firms were also asked what they see as their biggest challenges for the next 12-24 months. Around a quarter (27%) highlighted issues around processes and financial efficiency, while an even more significant 36% saw the recruitment and retention of quality staff as their key concern.

Mergers and Acquisitions

Last year, a quarter (25%) of firms said that they had carried out a merger or acquisition in the previous 12 months. This year’s research shows that figure dropped slightly to 18% but it suggests M&A activity is nonetheless very much alive and well.

Some of the merger activity in the last year further underlines the continuing consolidation in the sector, such as Howard Kennedy FSI and CKFT; Bircham Dyson Bell and Ambrose Applebe; and Blake Lapthorn and Morgan Cole.

More notably is the influx of law firm aggregators (including publicly-listed legal businesses) and franchise operators that was created by the LSA. Last year a quarter of firms (26%) said they had been approached by a legal consolidator, but that has now jumped to 36%.

However, opinions of those businesses seem to have worsened: in 2013 over a third (36%) of those who had not yet been approached said they would consider joining such a group, but now only 14% would consider it. In an improving economy, it seems more legal practices are willing to go their own way.

Service lines and Mergers & Acquisitions


There was also an increase in employment work, another positive sign for the economy...

Looking forward to the coming year, 91% of firms now see property as a sector for growth potential and 82%feel the same about corporate work.

The financial ratios section of our 2014 SME Legal Practices Survey is once again based on a review of the latest available published accounts obtained from Companies House and covers accounting periods up to 30 June 2013.

As previously stated, the review focusses on the accounts of independent practices in London and South East England. The analysis is based upon more than 70 SME firms with turnovers up to £35 million.

The comments that we have received indicate that firms have seen the trend towards recovery, established since 2010/11, continuing in 2013/14, but with ever increasing pressure on profit margins. The statistics we present in the analysis section support this view. Recovery brings its own challenges which make the monitoring of performance, and the ability to benchmark ratios and statistics of one’s firm against industry competitors, as vital as ever.

We have published our review in the hope that you find it instructive and we would be happy to provide further information to any interested parties.

Our analysis focuses on 3 key areas which together give readers a comprehensive view of how SMEs are faring in the current economic environment. These include:

• Turnover, staff and staff remuneration• Profits• Working capital finance and

borrowings

The analysis is segmented into 4 turnover bands referred to throughout the analysis as follows:

• Band 1 - <£10m• Band 2 - £10-£15m• Band 3 - £15-£20m• Band 4 - £20-£35m

Financial statistics

SME Legal Practices Survey 2014 | 11

The analysis is based upon more than 70 SME firms with turnovers up to £35 million.

Our analysis focuses on 3 key areas which together give readers a comprehensive view of how SMEs are faring...


Turnover growth

In 2012/13 the sector has grown for the third successive year. Following the initially high rates of growth seen in 2010/11 the rate has now normalised. Turnover growth was just under 4.5% in 2011/12 and has remained at a similar level in 2012/13, with a sector-wide average of 4%. As ever, this data contains more than one story.

As Graph 1 shows, growth is being enjoyed by firms at all size levels, from the smallest to the largest. Graph 1 also shows that a clear order is being established, with the largest firms showing the highest growth rate and the smallest firms the lowest.

In fact, it appears that the level of growth a firm can expect to enjoy is directly dependent on its size; the larger the better. However, Band 4 firms continue to peform at a level all their own, establishing an average growth rate in excess of 10%, well above the sector-wide average of 4%.

This overview does not give the whole picture. But by looking at the upper and lower quartiles for each band we gain an understanding of how the best and worst firms have performed. This gives an interesting, and for some firms quite a concerning, picture.

Best and worst

Band 4 shows some big winners - the top quartile firms have grown by 32% - and some more modest winners. However, even the bottom quartile firms in this band have managed to post positive although, at 1%, very modest growth figures. Some of the top achievers will be as a result of a merger, something that we continue to see at this level.

The view given by smaller firms is very different. The story for Band 1 firms seems to be that a great divide is appearing between those firms that are doing well and those that are really struggling. In 2012/13 the best firms continued to get better, with the top quartile averaging 16% growth compared to 15% in 2011/12. However, the worst firms are doing worse still, with the bottom quartile returning an average of negative 14% growth in 2012/13 compared to minus 8% in 2011/12.

This analysis suggests that the mergers we have seen in the sector in recent years are set to continue, as firms look both to grow and to gain protection from the failure risk faced by many small firms.

Analysis

Graph 1 - Turnover growth

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Turnover growth was just under 4.5% in 2011/12 and have remained at a similar level in 2012/13.

...the best firms continued to get better, with the top quartile averaging 16% growth compared to 15% growth in 2011/12.

Band 4 firms continue to perform at a level all their own, establishing an average growth rate in excess of 10%, well above the sector-wideaverage of 4%.


Staff number growth

As we highlight in the first half of this survey, the extent to which staff are being hired is a good barometer for both the health and confidence of firms in the sector. Our survey responses have shown that confidence is there and that many firms are now looking to recruit staff.

This optimism is starting to show in the figures (Graph 2), with a sector-wide average staff number growth of 3% in 2012/13. As we have seen for turnover growth, there is another “Band 4 and the rest” story here, with average staff number growth reaching 9% for these largest firms, boosted by mergers, but consistent with a tangible sense of expansion at this level.

Turnover per employee

Legal practices are simple structures. Their success is ultimately derived from the ability of their partners and fee earners to turn their work into fee income in a profitable manner. Accordingly, the value of fee income generated by each staff member is always a key measure of a law firm’s efficiency.

As we have seen, firms across the sector have experienced increased turnover and staff levels. If we look at the average fee income generated per employee by the firms across the turnover bands in 2012/13 with the same measure, for the same firms, in 2011/12, we note a slight fall. This suggests that the turnover growth we have seen over the past year has not, generally speaking, been generated as a result of increased staff efficiency, but primarily through hiring additional fee earners.

The exceptions to the trend are the firms in Bands 3 and 4, where the efficiencies, probably resulting from mergers, have had the most impact and increases in revenue per employee can be noted.

Despite a slight fall overall, average turnover per employee continues to exceed £100,000 in all Bands, which remains a healthy return.

In fact a slight reduction in this measure is not in itself a cause for concern. In expanding firms there is often a lag between the hiring of new fee earners and their reaching full productive capacity - this is normal. Problems arise when the expansion is speculative, the anticipated work does not arrive and firms are left with underemployed staff eating away at their profits and straining their monthly cashflow. This is the classic problem of “overtrading” in a recovering economy.

A look at the quartiles (Graph 3) shows that this strain is being felt by a number of firms.

At all sizes, the top quartile firms average fees are in excess of £200,000 per employee. We will look in more detail at the costs of staff remuneration and at firm profitability later on, but by any measure this is the hallmark of what are clearly very profitable firms. The firms at the bottom do not have such cause for optimism. Average fee income per employee in the fourth quartile is slightly over £60,000. In a climate of rising firm overheads and given basic salaries, this is an insufficient return on cost to generate a meaningful profit.

Graph 2 - Staff number growth

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Band1st Qtl 2nd Qtl 3rd Qtl 4th Qtl...success is ultimately derived

from the ability of their partners and fee earners to turn their work into fee income in a profitable manner.

Problems arise when the expansion is speculative, the anticipated work does not arrive and firms are left with underemployed staff...


Remuneration per employee

Whilst staff numbers grew, the average cost of each employee remained effectively stagnant between 2011/12 and 2012/13 (Graph 4). The average across the sector was £43,000 in both years. This measure is inclusive of salaries and other direct staff costs, such as social security contributions, and combines both fee earners and administrative staff.

As one would expect, pay rates are higher in the larger firms, the average pay in Bands 3 and 4 reaching £49,000 whilst in Band 1 the average sits just below £40,000.

The difference between the top and bottom firms is not so great when it comes to rates of pay as we see in many other measures. The top quartile payers average remuneration per employee of just over £60,000 in both 2011/12 and 2012/13, the bottom quartile paying around the £30,000 mark.

Stability in the cost of staff will of course be welcome by all firms, however it should not be assumed that this will continue to be the case. The wider economy only just got back to its pre-recession output levels and pay awards continue to lag behind, held back by years of austerity and some remaining spare capacity in the labour market. It is inevitable that pay levels will start to rise again and it is likely that the legal sector will be leading the trend.

With the continuing demand in the sector for taking on new staff that we have already noted in our survey, clear signs are there that pay offers will need to increase in order to recruit new staff in a competitive market. This has the knock-on effect of pushing up pay for existing staff in order to retain them. Keeping staff costs under control will undoubtedly be one of the sector’s greatest challenges as the economic recovery continues.

Turnover to remuneration ratio

We have seen that both turnover and staff numbers have been increasing, but that staff efficiency and the cost of employees have stagnated. In order to interpret how all of these drivers have been affecting firms’ profitability we need to combine them to look at the turnover to remuneration ratio. This is the amount of fee income that a firm can expect to generate from each £ spent on remunerating its staff, or to put it another way: how much of each £ of a firm’s fee income is spent on paying its staff.

As we have explained in each legal practices survey that we have presented, the turnover to remuneration ratio is the key profitability measure for all law firms, with the rare exception of the few that generate the majority of their income from the work of the partners, somewhat akin to barrister chambers.

As a long-term benchmark, a firm’s turnover to remuneration ratio should not fall below 2. To remain truly healthy it should be maintained at a level of at least 2.5. At this level, for every £100,000 of fee income, £40,000 is spent on staff and £60,000 goes toward overheads and profit.

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Graph 4 - Remuneration per employee

...the average cost of each employee remained effectively stagnant between 2011/12 and 2012/13.

...firms in Band 4 show the highest average ratio, approaching 2.9...

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Graph 5 - Turnover/Remuneration ratio

Graph 5 shows that, on average, firms in the sector are continuing to achieve this 2.5 benchmark. Most encouragingly it is being achieved by firms in all Bands. As we might expect, firms in Band 4 show the highest average ratio, approaching 2.9, and firms in Band 1 the lowest, just over the minimum 2.5.

The trend as the economic recovery took hold, from 2010 onwards, has been for the turnover to remuneration ratio to steadily improve, the overall sector average crossing back over the 2.5 mark in 2010/11. Overall, this trend has been slightly reversed this year. In fact, there is a distinct split in fortunes depending on the size of firms: Bands 1 and 2 have fallen back slightly, whilst Bands 3 and 4 show continued improvement, reaching a 5 year high for this measure in 2012/13.

The results we see here are wholly consistent with the statistics we have looked at already. Staff efficiency, measured by turnover per employee, has fallen in Bands 1 and 2 but increased in Bands 3 and 4. With staff costs remaining largely the same across all four Bands (Graph 4), we would expect the trend in staff efficiency to be matched when we look at the turnover to remuneration ratio, which is essentially a measure of staff profitability.

The same message can therefore be taken from a review of the quartiles, and we make no apologies for repeating it. The worst performing firms, characterised by a fourth quartile average of 1.90, are not earning enough from their staff in order to return a normal level of profit over the long term (remembering the minimum threshold of a multiple of 2). This clearly leaves room for further mergers to extract valuable work from struggling firms. We would also repeat our warning to Band 1 and 2 firms that have taken on staff on the back of the recovery yet to see the anticipated level of work come through: avoid the trap of rose-tinted glasses and take action to ensure under-occupied staff are fully productive before serious cashflow problems take hold.

The overall message remains positive however. The majority of firms in the sector are doing well and with significantly stronger performances than they were enjoying three and four years ago.


Bands 3 and 4 show continued improvement reaching a 5 year high...


Profits

The logical next step is to look at how the reasonably strong staff profitability figures we have seen are reflected when it comes to the bottom line.

We will look primarily at the operating profit level (fee income less direct costs and operating overheads).

Operating profit per partner

Overall there has been an increase in average profit per partner (Graph 6), from £154,000 in 2011/12 to £172,000 in 2012/13. This trend has been enjoyed by firms in three of the four Bands. The improved profitability for Band 1 firms is particularly encouraging, given the flat results of the last couple of years.

It is however Band 4 firms that have really driven the increased profitability in 2012/13, carrying their strong turnover growth through into an improving bottom line, with an 18% increase in per partner profits to just under £260,000.

Band 3 firms show a slight reduction in profit per partner compared to 2011/12. However, last year’s results were exceptionally strong, nearing the levels achieved by Band 4 firms. A slight slip back from this level of performance could well be expected and a per partner profit figure of £193,000 remains healthy and is ahead of levels noted in 2009 and 2010.

These average profits figures are good news for the sector, but we deliver them with two warnings for the future.

Firstly, it must be noted that practice overheads continue to rise, with professional indemnity insurance costs and office rents in London and the South-East leading the increases. These will continue to put pressure on firms’ profits through 2014 and 2015, especially in a climate where downward pressure on fees still seems to be felt strongly. We have already seen that the level of turnover growth is normalising around 4% per annum, not sufficiently greater than general inflation to be able to absorb continued ahead-of-inflation rises in overheads. For the long-term health of the sector, rents, and particularly professional indemnity premiums, need to stabilise.

Secondly, it only takes a look at the quartile results to reinforce the message that there are a number of firms that continue to struggle (Graph 7). In particular, the bottom quartile firms in Bands 1,2 and 3 are not generating profit levels that we would consider sustainable in the long-term. There are firms at all of these size levels that continue to generate no more than £60,000 profit per partner.

Whilst this may seem to be a reasonable return on capital, it is clearly scant reward when you factor in that it also needs to pay for a full year’s work as a partner of a law firm. With the picture of increasing pressure from overheads that we descibed before, these profit figures may well be squeezed lower still. Consolidation therefore remains an attractive option, allowing the pooling of overheads and relieving the pressure on firms that may otherwise be struggling to make it under their own steam.

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Graph 6 - Operating profit/partner

These good average profit figures are good news for the sector, but we deliver them with two warnings for the future.

...rents, and particularly professional indemnity premiums, need to stablise.

...improved profitability for Band 1 firms is particularly encouraging...

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Graph 7 - Operating profit/partner by quartile

www.hwfisher.co.uk SME Legal Practices Survey 2014 | 17 www.hwfisher.co.uk17 | SME Legal Practices Survey 2014

...quartile firms in Bands 1, 2 and 3 are not generating profit levels that we would consider sustainable in the long-term. There are firms at all of these size levels that continue to generate no more than £60,000 profit per partner.

Profits are one thing. For any business to be successful they must also be able to turn the work they have performed into cash in the bank. This is even truer for legal practices than for many other businesses due to the predominance of fixed overheads in the cost base. The rent and salaries bills need to be paid, month in and month out, and require good working capital management and a healthy flow of cash, in order to do so. Working capital management has always been vital for law firms, but it is not something at which they have traditionally been very good.

Economic recovery can be a dangerous time. 2012/13 has seen continued growth in turnover and growth in staff numbers, and we have already referred to the lag that exists between staff being paid and their generating income for the practice. The “lock-up” period is that between fee income first being recognised in the accounts, via accrued income, through uncollected bills in “trade debtors”, until finally it reaches the practice bank account. With rising overheads it becomes more vital than ever to minimise this “lock-up” period.

As work in progress periods and valuation methods vary from specialism to specialism, and from firm to firm, we have concentrated on the area of working capital management that can be objectively compared; the amount of time it takes to collect debts.

Debtor days

The average debtor days figure in 2012/13 was 111 days. This is very much in line with the norm for the sector that we have noted over the past four years, and is a slight increase on the 2011/12 figure. It is however quite a long time for a firm to have to fund its overheads, representing a total of nearly four months between work being billed and it being collected. If one adds a month or two for pre-billing “work in progress”, lock-up can be 6 months or more.

The difference between the best and worst performing firms can be seen by looking at the quartiles (Graph 8). The very best firms in the sector achieved a figure of just under 30 days, 1 month, which is starting to meet the standards set by other types of business in the wider corporate world. The best quartile registered figures up to 73 days, whilst the majority of firms, to quartile 3, achieved figures up to 139 days. The weakest firms, in the fourth quartile, achieved figures of 140 days or more. The very worst firms in our survey for collection of debts came in with debtor days figures of over 250 days - these were personal injury specialist firms, who are in a world all their own when it comes to “lock-up”, characteristic of the risky industry in which they operate and these firms’ relatively high instance of failure.

The levels of the quartiled thresholds is fairly consistent between the size Bands, demonstrating that firms of all sizes face the same considerations when it comes to the collection of debts.

When working capital becomes tight, with their extended “lock-up” periods, something many firms will be finding to be the case, it is natural that they turn to borrowings to fill the void.

Borrowings

Over recent years we have seen more and more examples of relatively short-term lending being offered to law firms, from specialist firms that have seen lucrative, relatively low risk opportunity. Typically the offerings range from traditional overdraft facilities through specific loans to fund annual professional indemnity and practicing certificate renewals, partner tax payments on account and now even regular bills such as VAT. Whilst these offerings are no doubt tempting, firms need to be careful. Although relatively easily available, borrowing is not free and the stated (sometimes reasonable) interest rates are often inflated by other charges.


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250

300

350

400


Debt

or d

ays

Band

Graph 8 - Debtor days by quartile

As firms become more dependent on borrowings it becomes increasingly difficult to reverse the trend.

Working capital finance and borrowings


More dangerous still is the precedent that starts to be set. As firms become more dependent on borrowings it becomes increasingly difficult to reverse the trend. When interest rates rise, as they are bound to do in coming years, if not months, the cost of debt leaps, and firms already struggling with ever-increasing overheads find another big bill added to the pile.

The other risk that a climate of low cost borrowing carries with it is the adverse effect it can have on working capital management. When it becomes more straight-forward to take out another loan than to chase hard those debtors that stubbornly will not pay, the tempation is to do just that. It is for this reason that loans for such purposes as funding the VAT bill are dangerous - these are bills that a firm should be able to fund out of working capital: if they cannot do so then something has already gone wrong. Borrowing in these situations masks the real problem and adds to the financial straight-jacket the firm finds itself in.

The number of firms in the sector that are making use of borrowings is increasing (Graph 9). In 2012/13 nearly 9 out of 10 firms have some kind of borrowings on their balance sheet. By borrowings we mean bank or other external borrowings, not amounts due to partners, which, for these purposes, is generally considered equity.

There are some differences between the size Bands.

The largest firms, Band 4, have been the most stable in their use of debt, fluctuating slightly from year to year, but showing a general trend that four out of every five firms in this Band carries debt. This is consistent with the more corporate approach and settled business plans characteristic of firms of this size.

Band 2 firms register the highest figure. In 2012/13, every firm in our survey that fell in this Band featured some form of borrowings on its balance sheet.The most interesting story is perhaps for Band 1. The trend for these firms is a steady increase, which for the small firms really represents quite a fundamental shift in approach. Traditionally, there have been a sizeable proportion of small firms that have no external borrowings whatsoever, the practice always being funded by funds injected by the partners and then sustained on its working capital. By 2012/13 it appears that this type of firm is an endangered species. Over 80% of Band 1 firms in our 2012/13 survey show some form of external borrowing, increasing significantly from just over 60% in 2009/10.

The most common type of debt continues to be bank overdrafts and other bank loans, representing nearly 60% of total borrowings in the sector, although the use of long-term borrowings has also been increasing. By 2012/13 over 60% of firms had some long-term debt, up from 47% in 2009/10.

Whilst it is clear that the number of firms with borrowings has increased, we also need to consider the extent to which they are borrowing, as ultimately this is where any dangers signs can be seen.

We have looked at this area through two measures: the extent of borrowings expressed as a proportion of total fee income for the year (Graph 10), and gearing: the proportion of total financing of the business (ie. debt plus equity) that is represented by debt (Graph 11).

Borrowing in these situations masks the real problem and adds to the financial straight-jacket...

Graph 9 - Proportion of firms with borrowings

40%

50%

60%

70%

80%

90%

100%

2009/10 2010/11 2011/12 2012/13

% Fir

ms w

ith b

orro

wing

s

Year


Over 80% of Band 1 firms in our 2012/13 survey show some form of external borrowing...

0

10

20

30

40

50

60

70

80

90

2009/10 2010/11 2011/12 2012/13

Borro

win

gs a

s day

s of f

ee in

com

e

Year


Graph 10 - Borrowings as days of fee income


The overwhelming story told by Graph 10 is one of consistency. This is reassuring, as essentially what it demonstrates is that whilst the number of firms that are using debt is increasing, the extent to which these firms make use of borrowings is remaining reasonably constant. On average total borrowings represent just under 50 days of fee income, and have done so in each of the past four years. Band 3 shows a little more variability and has the highest figure at around 70 days in 2012/13, whilst Band 4 shows a slight reduction and the lowest figure, at just under 30 days.

Borrowings of one and a half month’s fee income, the average figure, is a sustainable level of debt and can be considered reasonably prudent. Unfortunately, not all firms are achieving this.

The firms with the highest borrowings against fee income, those in the fourth quartile, average a figure of 116 days - four months’ worth of fee income, a significantly higher, even dangerous, debt burden. The highest figures seen in this year’s survey were in excess of 200 days, nearly seven months’ income. With an average operating profit margin of 30%, it will take these firms almost two years to pay off their current debt level if they were to dedicate all of their profits to this purpose. These firms have a significant debt dependence and will no doubt face a potentially intolerable risk from rising interest rates in the coming years.

Graph 11 shows the level of gearing shown by those firms that make use of debt. The average gearing across all firms with debt is 51%. In all Bands at least half of firms have gearing figures of under 50%, in other words, less than half of their financing is in the form of debt, the other half being partners lending money to the business. In Band 4 this is the case for over 80% of firms.

There are also, however, some very highly geared firms in the survey. In both Bands 1 and 2, for 10% of those firms that use debt, it has effectively converted into the sole source of finance, with no equity being retained in the business. This is a high risk method of financing a firm’s working capital requirements and it is no doubt borne out of not just the convenience of borrowing, but also out of necessity - a firm that is not generating sufficient profits to meet its partners’ living costs will never be able to accumulate equity, and debt will therefore be the only source of finance available to fill the gap. As we have seen already, there appear to be plenty of firms in the sector that fall into this category.

The highest figures seen...were in excess of 200 days, nearly seven months’ income.

...it will take these firms almost two years to pay off their current debt level.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

All Band 1 Band 2 Band 3 Band 4%

Gear

ingBand

< 25% 25 - 50% 50 - 75% 75%-100% >100%

Graph 11 - Gearing


The key messages from this year’s survey are optimism combined with caution.

The sector has continued to grow. The rate of growth has fallen but appears to have stabilised. Many firms have been successful in converting this growth into profits.

Overheads continue to increase, both through increased staff levels and as a result of escalating rents and professional costs. There has been no visible improvement in working capital efficiency and the use of borrowings is increasing. In this climate, firms must be ever-more vigilant to monitor their profitability, and above all their cashflow, very closely and to spot and react to the warning signs early before problems spiral out of control. These issues are faced by all businesses in a recovering economy, but the particular features of the legal services sector means that law firms will feel these pressures more acutely than most.

What is clear this year is that the gap between the strongest and the weakest persists and continues to widen. There are firms underachieving in all key measures. One thing appears to lead on to another: low staff productivity leading to profit levels too low to be sustainable, resulting in an inability to retain and grow equity in the business and causing an over-reliance on debt finance.

Many of these firms will carry out valuable work, but may be struggling with their overheads in their current structure. Such firms will be targets for the mergers and consolidations that we have seen in the sector and that look set to continue for the foreseeable future.

Contact us

For information about our services to the Professional Practice Sector or for further details on our annual survey please contact:

Paul BeberE [email protected] 020 7380 4961

Jamie MorrisonE [email protected] 020 7874 7983

Nauzer Siganporia E [email protected] 020 7380 4965

David BregerE [email protected] 020 7380 4943

Conclusion

...key messages from this year’s survey are optimism combined with caution.

In this climate, firms must be ever-more vigilant to monitor their profitability and above all their cashflow...and react to warning signs early before problems spiral out of control.


Summary

Turnover growth (%)

2012/13

2011/12

2010/11

2009/10

Staff number growth (%)

2012/13

Turnover per employee

(£’000)

2012/13

2011/12

Remuneration per employee

(£’000)

2012/13

2011/12

2010/11

2009/10

Turnover/remuneration ratio

2012/13

2011/12

2010/11

2009/10

Operating profit per partner

(£’000)

2012/13

2011/12

2010./11

2009/10

Borrowings as days of fees

2012/13

2011/12

2010/11

2009/10

Debtor days

Low

First quartile

Second quartile

Third quartile

High

Firms with borrowings (%)

2012/13

2011/12

2010/11

2009/10

Gearing

<25%

25 - 50%

50 - 75%

75 - 100%

>100%

Top quartile

19%

17%

19%

14%

14%

210

226

61

62

51

50

3.58

3.70

3.42

3.28

285

277

269

277

4

4

5

7

All firms

29

73

108

139

347

86%

81%

80%

72%

33%

24%

17%

19%

7%

Second quartile

5%

7%

4%

2%

5%

119

121

45

45

39

37

2.74

2.77

2.65

2.52

194

173

172

176

21

25

21

21

Band 1

29

70

102

146

276

86%

77%

74%

63%

30%

25%

25%

10%

10%

Mean

4%

4%

3%

0%

3%

121

124

43

43

37

36

2.64

2.70

2.57

2.46

172

154

160

159

47

48

48

47

Band 2

35

69

119

139

169

100%

82%

82%

76%

30%

20%

20%

20%

10%

Third quartile

1%

1%

-1%

-4%

0%

87

86

37

37

32

31

2.36

2.39

2.28

2.24

129

111

116

111

47

47

47

47

Band 3

49

82

111

132

164

75%

92%

83%

92%

50%

0%

0%

50%

0%

Fourth quartile

-9%

-7%

-9%

-13%

-5%

64

65

30

29

25

23

1.90

1.91

1.92

1.82

80

60

81

61

116

115

114

112

Band 4

47

87

125

153

347

80%

80%

90%

70%

33%

50%

0%

17%

0%


These issues are faced by all businesses in a recovering economy, but the particular features of the legal services sector means that law firms will feel these pressures more acutely than most.


HW Fisher & CompanyBusiness advisers - A medium-sized firm of chartered accountants based in London and Watford.

Related companies and specialist divisions:

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© HW Fisher & Company 2014.Print date: October 2014. All rights reserved.

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Sme legal practices survey 2014

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