We need to talk: How to communicate financial information to partners

Sarah Wilkinson, finance director at Field Fisher Waterhouse, shares her insights in communicating financial information to partners

Five things you will learn from this Masterclass:

1. How to approach communications with new and existing partners

2. How to deliver targeted messages which drive the right partner behaviours

3. How to encourage partners to fill their fee income gaps

4. How to develop a firmwide focus on financial performance

5. How to minimise the ‘bad stuff’ and improve profitability

 

Ultimately, accounting is about driving the right behaviours amongst partners – persuading, helping and challenging them to operate in the most profitable and efficient manner, and encouraging them to be the best amongst their peers.

However, apart from in the most specialised niche firms, modern law
firms have a range of practices, each of which have slightly different business models. In most firms, practice areas happily coexist with very different pricing, leverage and structures.

When communicating to a group of partners, the message needs to be balanced so that it remains appropriate to each part of the business. There is definitely a balance to be achieved between blanket communication to all partners within the firm and tailored communication to groups of partners. Both can work well, so a ‘layering’ of messages is ideal.

Every firm has a unique culture amongst its partners, so it’s also important to acknowledge this when conveying messages to them about the firm’s financial performance. What is appropriate for some firms will be very wrong for others, and in international firms with different languages and cultures, the position is even more complex.

In looking at reporting to partners, we need to make a few important distinctions. Firstly, there is the accurate and timely reporting of the financial performance of the firm, along with the profitability of the different offices and/or practice areas within it. This needs to be informative, to explain budget variances, year-on-year movements, and to report factually on the firm’s financial position, cashflow and trading performance.

Since partners tend to prefer charts and a written narrative to a series of charts and tables, a mixed format can work well. There is a difference in interest in financial matters amongst partners, with some preferring key messages and others preferring a longer comprehensive reporting pack. It is a balance which is difficult to achieve in practice. In terms of daily or weekly reporting, succinct key messages, dashboards, and financial headlines are all invaluable to busy partners running practice areas.

Some firms adopt the view that, in practice, the majority of the partnership are predominantly focused on their own practice areas. So, they believe an in-depth financial understanding of their practice area, its utilisation, debtors, recovery rates, pipeline of work, cross referrals with other parts of the practice, leverage and profitability is all that really matters to most partners because it is all that they can reasonably be expected to control.

Meeting with the partners in each practice area fortnightly or monthly, providing them with their own ‘financial headlines’ and areas for focus in the short-term can be very powerful in motivating them all to work towards a common goal, especially if this involves a working capital, fee income or profit target. Practical examples with which individual partners can readily identify are always helpful.

It is important to ascertain the level of understanding of newly-appointed partners in particular with regard to the firm’s finances. I would recommend training/discussions with newly-appointed partners to ensure they understand what to expect in terms of financial reporting and why they should look at these reports. It’s also a good idea to provide them with a glossary of terms, so that they understand statistics such as countback debtor days, lock-up and other measures relevant to them.

It is equally important to have a similar discussion with newly-arrived lateral partners, so that differences from how things were done at their previous firms can be explained. Incoming laterals also provide useful insights into how the emphasis of reporting might change in a fairly stable firm where the reporting format has remained unchanged for some time.

What really matters?

What really matters in a law firm from a financial perspective can be broken down into three main headings:

1. profitability;

2. working capital; and

3. working towards the firm’s agreed strategy.

Depending upon the point in the cashflow/profit cycle, it may be appropriate to emphasise some of these points more than others when communicating messages to partners, although you can never underestimate the importance of rigorous working capital discipline. In the past I have likened this to my ironing pile at home, something not be put off for another day.

Explaining the impact on profits

When looking at profitability, every percentage matters. I have found that it can be very powerful to explain to partners the impact on their profits of taking or not taking action in certain situations.

Figure 1 provides an example of how this can be broken down for partners.

In scenario A, we have a law firm generating a reasonable return for its equity partners (30 per cent).

In scenario B, fee income declines, costs remain the same and bad debts increase to four per cent of fee income. The result is a 26.7 per cent decline in partner profits.

In scenario C, partners realise that if no action were taken they might be in a situation such as that in B. So they work hard to improve fee income, focus on working capital to reduce bad debt risks and reduce costs accordingly. Their profits are only 3 per cent lower in the end.

Targeted messages

Some firms have a natural inclination to finance organic growth from retained profits (partner current accounts chiefly) and through working capital improvements.

When looking at how to fund investments, you may wish to explain to partners how simply by improving working capital they could eliminate the firm’s overdraft, freeing up funding to permit further growth, perhaps along these lines:

• if every £1 of work in progress over two months’ old is billed this month at a recovery rate of A%;

• if debtor days improve by B days;

• if we improve our margins through avoiding the writing-off of post-completion time and time lost through under-recorded time entries;

• then profits and cashflows will improve by £C;

• and £C would be sufficient to permit investments D, E, F and G.

This is just one example of what I call ‘IF scenarios’: many targeted messages to partners can be expressed in this way to drive the right behaviours.

Implementing strategy

Almost all law firm strategies involve growth of fee income. This is one area where it can be difficult to explain to partners the value of working collaboratively, cross-selling effectively, embedding clients to become clients of the firm rather than of one practice area, generating further work following the first initial instruction, and so on.

Almost every firm has a fee income gap which is the difference between the mathematically-possible fee income from every fee-earner and partner working at 100 per cent utilisation and recovering close to 100 per cent of their headline charge-out rates and the actual realistic fee income they are all presently achieving.

At the margin, almost all of the incremental fee income in working to fill this gap percolates into additional profits for equity partners, so the impact on profits can be significant. We can return to the IF scenario in trying to encourage partners to fill their fee income gaps, as follows.

IF X partners can cross-sell an additional £100,000 of work to another part of the firm, or if Y partners can generate an additional £100,000 of work each from lapsed clients from whom they have not received instructions in the past year, then fee income and profits will improve significantly.

IF we had done things differently, we might have won a further £100,000 of work from recent pitches and tenders. Aggregating this into the context of an additional profit share of £Z per partner can help towards driving different behaviours.

Methodologies such as value creation and how firms in other industries use technologies to work together in networks has some potentially interesting insights into how law firms can change to survive the current recession and the upcoming changes that the Legal Services Act will bring.

At a basic level, value flow theory enables a network of clients, contacts and partners to produce much more value than a firm could by merely using its internal capabilities. Law firms need to analyse and examine how they are organised not only in terms of managing individual matters, but also in terms of client and introducer networks. Conveying such messages to partners can be as important as delivering a comprehensive pack of financial reporting each month. Finance has a role to play in helping business development to drive the business forward, rather than merely reporting on its past.

To be truly effective, we should not stop at communicating financial information to partners. Involving business service teams, assistants and secretaries can be very motivating for them, especially when they realise that they all have an important contribution to make.

This can take the form of submitting timesheets promptly, driving a harder bargain with suppliers, implementing new systems to streamline processes, ensuring that invoices are issued on time and sent out to clients promptly, and assisting with credit control, thereby freeing up partners to win new business and grow the top line of fee income further.

Minimising the bad stuff

Those partners with corporate clients will understand the phrase EBITDA, referring to earnings before interest, tax, depreciation and amortisation charges. Some refer to this measure as earnings before the bad stuff, or EBBS.

Law firms also need to minimise their ‘bad stuff’, which might include writing off disbursements and bad debts, difficult situations with unhappy employees which might require additional payments and/or legal costs, failing to recover all soft disbursements fully from clients, payments in lieu of negligence claims and so on.

Working smarter, streamlining processes, minimising risks and reducing the human effort of dealing with these things are important in improving profitability, as much as growing the top line of fee income.

Explaining the impact of the bad stuff is terribly important. If minimising this adds a few percentage points to profits each year, and partners are reminded of this, they should all take steps to ensure they have efficient practices with happy motivated teams, and so on.

I have also used the term ‘utopia’ before in this context. If we lived in a perfect world, with no bad stuff, no need for provisions and write offs, no time costs, where time recording is complete and instantaneous, and so on, profits per partner would increase by £X. Realistically, if we can get to a profit improvement of £Y, which is half of £X, that should be a very encouraging, enabling and motivating message to partners.

Naughty step

So far, we have talked about engaging partner collaboration and involvement in a positive way. Unfortunately, from time to time, it is necessary to communicate to partners by publishing a sinners list – for example, those with the largest unpaid bills over a few months old, those with the largest number of missing timesheets, the lowest recovery rates, poorest lock up, and so on.

The effectiveness of this ‘naughty step’ approach depends on the culture of the firm, the provisions of equity partner sanctions within the partnership agreement and the nature of the individuals concerned.

Market incentives

The legal sector will inevitably undergo a period of change following the Legal Services Act permitting multi-disciplinary practices and external ownership of UK law firms from October 2011.

It is likely that law firms will, in general, move further toward being run and managed along modern corporate lines rather than as traditional partnerships underpinned by a fairly rigid lockstep.

This structural change brings an added incentive to be as efficient and as profitable as possible. Effective financial communication in driving more profitable and efficient behaviour throughout law firms has never been so important.