Profits shrink as growth continues

The Lawyer/Pricewaterhouse Coopers1998 survey reveals some worrying trends, say Alistair Rose and Denise Catterall. Alistair Rose and Denise Catterall lead the Pricewaterhouse Coopers professional partnerships' group and specialise in providing accounting, tax and business consultancy services to law firms.

Over recent years, the annual survey has traced the industry's progress towards improved financial management. This year, as a result of buoyant economic conditions, we might have expected a combination of improved efficiencies and increased turnover to produce strong profit growth. So why has this not generally been the case?

While the 1997/98 survey results show the continued trend of increased billings per partner and overall profitability, we have seen a reduction in the rate of growth of profits. We have also, disappointingly, not seen any real improvement in the key ratios and benchmarks.

In certain instances there has actually been a decline in performance, for example, in working capital control. Overall, one is left with the view that firms, generally, have experienced a busy and productive year but have not had the time or, perhaps, the inclination to continue re-engineering their practices.

In addition to the day-to-day competitive pressures that law firms have had to face over the past year, other major issues have had an impact on their practices, including:

the introduction of conditional fee arrangements;

the potential financial impact of the shortfall on the Solicitors Indemnity Fund; and

the impact of the change in partnership tax assessment and inclusion of work in progress.

All of these factors will place strain on the working capital of the practice. Firms facing the catch-up charge on previously unrecorded work in progress anticipate that this will be funded partially by an increase in partner capital requirements and partly by bank borrowings direct into the partnership. Both will clearly impact on partners' net income after interest.

The taxation charge relating to the recognition of work in progress on a “true and fair” basis was an area of focus for this year's survey. With guidance on the Inland Revenue's interpretation of “true and fair” anticipated this autumn, we asked firms which do currently include work in progress in their accounts what percentage of full selling price it constituted. As expected, a broad range of responses – from less than 25 per cent to more than 75 per cent – illustrated the historic flexibility within the current system. While the type of work undertaken by the firm may well dictate varying methods of valuation, we believe that any valuation over 60 per cent of selling price must be questionable. Firms which do carry a high valuation of work in progress are not only accelerating their tax charge but, if the same valuation is used, may be overpaying current partners.

Improved efficiencies in working capital management will help to mitigate additional funding requirements but this is still an Achilles heel for many firms. Again it is the more profitable firms which appear to be less vigilant. Of those firms achieving profits in excess of 30 per cent of fees billed, over 40 per cent had 175 days working capital outstanding. While this may reflect the type of work performed, we maintain that concerted management action can make a large impact in a short period.

A further major issue in the near future is the impact of a slowdown in the UK economy and, indeed, the potential for a “hard landing” as forecasted by some economists. In the event that this is the position, we believe that many firms have not taken the opportunities offered during the recent buoyant economic conditions to re-engineer their practices and to enable them to deal effectively with a downturn.

The lack of re-engineering is evident from the fact that we have seen no improvement in partner to qualified staff ratios and a small deterioration in the support to practice staff ratio. We have consistently reported that firms performing well at the profit line have better than average staff to partner ratios. It is surprising that there has been so little improvement in the ratios and that many firms continue to operate on low partner to staff ratios. Given the large amounts invested in IT by many firms in recent years, this is disappointing.

IT has again been a key area of expenditure, with 14 per cent of firms spending over £3,000 per fee earner on IT. However, 85 per cent of firms responding stated they were unaware of the level of cost savings made from their IT investment. Like any other expenditure, the anticipated benefits should be clearly considered and then monitored to ensure that they are realised.

The impact of year 2000 and, for some, the EMU, will only add to IT costs placing more importance on cost control in this area.

We commented last year on the relatively low amounts spent on training. This year sees a continuation of this trend with 85 per cent of firms spending less per fee earner on training (82 per cent in 1997). With ever-increasing salaries commanded by professional staff, it would appear that savings are having to be made in the level of training. This highlights the current focus by firms on short term objectives (maintaining current profitability), as opposed to a long-term strategy.

One of the main reasons for pressures on profitability is increasing staff costs and declining staff retention. A number of firms have decided not to replace profit-related pay and the level of commercial and skills training offered to staff has decreased. Both these factors may impact on retention rates further. The increasing staff costs re-emphasise the need for focusing on working practices.

The best performing regions in this year's survey were Scotland and the West Midlands, with 88 per cent of firms in both regions reporting increased profits (compared with a combined regional average of 81 per cent). Fifty seven per cent of firms in Scotland also reported an increase in profits of more than 10 per cent.

Central London has had a relatively poor year compared to 1997, with only 42 per cent of firms reporting increased profits of more than 10 per cent, compared with 65 per cent last year.

The worst performing regions in 1998 were the North West with only 63 per cent of firms reporting increased profits and the East Midlands and Wales with 67 per cent of firms reporting increased profits.

For many firms, 1997/98 will be viewed with satisfaction due to increased utilisation and profitability. However, the professional marketplace is continuing to develop rapidly and this will create opportunities for some just as much as threats for others.

Those firms which are most likely to succeed are those which identify their core profitable focus, build a business plan around it and invest in IT, financial and HR resources to deliver the strategy. The fundamentals of running a successful legal partnership are little different from any other commercial organisation and increased focus on financial management across all sizes of firms is a prerequisite to success.

Our survey has established benchmarks for firms in a number of areas. A comparison against others will help firms understand the issues and will help in setting their strategy for facing an environment of threat, competitive pressure and change. Those who choose to ignore the early warning signal clearly sent by this year's responses may do so at their peril.