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Budget Balancing Need Not Be an Arcane Art
by Barbara Lewis MBA and Dan Otto MBA

Some law firms do little planning, if any, when it comes to projecting future income and expenses for the firm. They have no budgets and no cash flow projections. While it may be difficult to project future income and expenses, chances are that it will mirror similar growth trends in the past, unless there are extraordinary circumstances.

Operating without a budget and projections is foolish. The budget should be used as a goal. The budget is segmented into two areas: revenue and expenses, from which profit and profit margin can be calculated. Law firms that have no financial goals in expenses and revenues don’t have a valuable target for which to aim.

Revenue projections are a function of past growth, marketing and seasonality. By tracking previous years’ growth, firms can estimate the future year’s revenue. Factors such as losing a big client, a change in the economy or marketplace can influence the revenue.

Most firms experience some type of revenue seasonality; that is, all months or quarters don’t generate the same amount of revenue. Yet many partners take the same draw each month. This results in stress for attorneys who wonder why they ‘re suffering from a cash flow crunch. Oftentimes, this happens in January when collections feel the result of low billable hours in December, due to vacations. However attorneys will go through the same stressful time each January because they failed to plan for a reduction in January’s revenues. Most firms experience some seasonality in revenue that lags vacations in the summer or holidays in the winter. The lag time is approximately the same period as the average collection days (the average amount of time it takes to collect fees).

Some seasonality is driven by a client’s business. For example, if a large client generates a substantial amount of business, then the client’s seasonality may affect the law firm’s revenue distribution across the year. By tracking seasonality, you can project revenue and profits (and the amount of money that you should draw each particular month).

Marketing can drive revenues as well. If the marketing plan includes speeches to your target audience, for example, you can estimate approximately how much revenue will be generated from this activity. The first time you do this projection, is difficult. However, by establishing a measurement system and tracking which of your marketing activities generate clients, you will be able to better project future revenues based on historical data. For example, one client recognizes that a speech given at a specific organization conference each year has generated one client per year, averaging $20,000. Other marketing activities can be linked to revenue as well.

Each year, law firms should examine their expenses for the previous year to calculate the expenses for the following year. Expenses can be fixed or can change by amounts related to inflation, additional employees, revenues or events. For example, the telephone expense is usually related the number of employees, marketing should reflect the revenues with about two to four percent designated for marketing. Web site development is an expense with a one-time costs of development but a monthly hosting fee.

In the expense analysis for the previous year, items that appear high should be investigated. For example, one firm found a huge messenger expense that was unnecessary. As a result the firm decided to use mail service unless documents were time critical. The savings was 75 percent for the postage and delivery expense. Expenses have seasonality as well. For example, taxes paid in April may reduce that month’s profits.

Each line item of expense is then projected for the next year using a specific factor, such as number of employees, or a set of factors, which could include inflation.

The annual projection, known as a pro forma, will give you good estimates of your revenues, expenses, profits and profit margin. These amounts are the targets and should be measured monthly and monitored for variance from that amount.

By monitoring this data, you can quickly ascertain problem areas. For example, when one of our clients discovered that his revenues fell slightly in the previous month that historically was his best month, he boosted his marketing campaign and finished the year on target. Had he not discovered the problem early on, he would have, undoubtedly, experienced a decrease in revenues that year.

By performing these calculations, you can estimate your monthly income and your profit margin each month. The average law firm profit margin in 30 percent before partner draws and can be as much as 60 or 70 percent for a small firm with only a few attorneys.

Cash flow is one of the biggest problems for businesses. By calculating revenue and expense projections, you will be able to estimate your monthly cash flow, which contributes to operating a healthy firm.

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