Getting to Know Your Cashflow

Getting to Know Your Cashflow

So you heard we had a bit of a scare on the cash front at the end last month?

Yes, I did.  What on earth went so badly wrong?

We just weren’t watching the cash side of things closely enough.  We knew we were making jolly good profits, but we’d lost sight of the cash outgoings.

OK, don’t tell me, let me guess.  You had the partners’ income tax to pay and the VAT quarterly bill as well, and you hadn’t set any money aside for them.

That was part of it.  We were making the accounting entries for the tax reserves, but we weren’t putting the money away.

It’s a common trap.  I know you’re aware that you don’t have to make tax reserves at all, since self-assessment came in, but we agreed ages ago it was prudent to do so.  Many firms still do have such reserves.  However, if you don’t put the money aside, into a separate account, then you’re really risking the money by treating it as part of the working capital of the firm.  You need to envisage the money as being held in trust for each of the partners by the firm, and so develop the discipline of setting it aside and not touching it.  Indeed, if you go ahead with the idea of converting to an LLP that we were talking about, then I’d suggest you don’t even hold it in accounts which belong to the LLP at all.  If you move it into an account or accounts in the names of some members as trustees, then it will cease to be part of the LLP’s assets, and you don’t need to worry about it being taken by the creditors if all goes wrong.

That’s a good idea.  But it wasn’t just the tax that caused the problem.

No.  I’ll bet part of it was the partners doing loads of billing at the end of the quarter, to meet their targets, and so bumping up the VAT bill.  After all, you mentioned you were making good profits, and it’s a fact of life that if the bills aren’t promptly paid, the VAT becomes a disproportionate problem.

How can we stop the problem happening in future?

Well, the first thing is to make sure that you know when a problem is going to occur.  That means watching your cashflow carefully.  Part of the problem is that most management accounting systems have a big hole in them when it comes to cashflow tools.  Most of them will give you historical reports, but what of course you need is a forecast to show what’s going to crop up in the near future.

Probably the best bet is to set up a cashflow forecast template.  I don’t think you’ve got one on your system, so what you’ll have to do is get someone to create a spreadsheet in something like Microsoft Excel.  That young manager you’ve got in accounts should be able to do it – he knows his way round your accounts system, and he’s also good with formatting spreadsheets.  He may need some help from your accountants in the first place.

By the way, be aware that cashflow management is not only already a requirement of Lexcel, but if the new Law Society Code of Conduct gets approved by the authorities, as hopefully it will later this year, then it will be a requirement of every single firm.


Isn’t it just a case of getting information from the accounts system?

Not entirely.  As part of your budgeting exercise, you should be able to predict what cash movements you are likely to have.  You’ll have to take some educated guesses, about things like the average speed of payment of bills.  It’s not just a matter of transposing figures from the accounts system.  You have to think it through, and make sure you cover all the cash items.  Some of them, like drawings, are of course in your control.  You’ve also got to take out some non-cash items, which occur in your nominals set-up, like depreciation.

So we do it for the year?

That’s your starting point.  It’s best, however, if it’s a rolling programme, so you up-date it every month.  That way, you can compare what’s actually happened against what your forecasts were, and see if there are any problems coming up which you hadn’t expected.  If you move it on all the time, it will also enable you, after a while, to identify trends, and things like seasonal variations in cash movements you may not have anticipated.  For instance, I wouldn’t mind betting that some of your recent problems were made worse by the Christmas effect!

What do you mean?

Well, Christmas and New Year now effectively take out two weeks’ work, but the cumulative effect is more than that.  Not only do you lose two weeks’ billing, at least, but also a lot of clients will put payment of your bills back.  The worst ones are those who only pay their bills once a month.  They can be quite grateful for the opportunity to gain an extra month’s credit by simply not doing their December cheque run, and so you don’t get your money for another whole month – just at a time you need it most.  And for those of your clients who do pay reasonably promptly – say a month after invoice - if you haven’t sent them a bill until after New Year, you won’t get paid until February, which is too late for the tax bills!

I see what you mean.  It’s true that we hadn’t expected things to be as low as they were, so I guess that may have contributed to the problem.  I think the thing that really got us so worried was that it all happened so quickly.  We felt fairly comfortable, and then it all went to pot in a matter of days.

Cash movements can be like that.  The problem is that many of the most important payments you make are cyclical, but tend to have different cycles, both in terms of length, and in terms of the start and finish dates.  Where real problems happen is where the cycles coincide, and a lot of payment dates all come together.  It’s a bit like waves coming together, and creating a freak result that you hadn’t allowed for.  Then you suddenly find you have to pay out partners’ tax, VAT, the office rent and the staff salaries all on the same day!  That’s where the monthly cashflow I mentioned above, though it’s an essential part of your planning, probably isn’t enough.

What else can we do?

I’d recommend having a short weekly get-together, to review what’s going to be happening in cash terms over the next week, and the next month.  Of course, part of that’s going to be guesswork, as you don’t know what bills are going to be paid by your clients – but you’ll soon develop the ability to make a pretty good average guess.  What you can be more detailed about is what payments are going to be going out of the account – what standing orders or regular direct debits are going to be paid, and what major bills you’re going to have to settle.

That sounds like a lot of work.

Not really.  Your accounts team will soon get the hang of putting the raw data together for you.  Your accounts manager can then discuss with you, and one or two others you may want to get involved, where you stand.  All you need is a single sheet with the headline figures on, like
·    What the opening bank account figure is
·    What your estimated income for the week / month is
·    What major regular commitments have to go out in that period
·    What significant irregular payments will have to be made in the period
·    What the closing bank figure is
·    How much leeway that leaves you against the facility you’ve got.

You’ll soon find you get used to dealing with the issues in ten or twenty minutes.

What can we do if we spot any problems?

Quite a lot really.  Let’s say you find you’re getting close to your limits, but you know that there are some good bills which your clients should be paying soon.  You can then try to identify whether there are any payments which you can realistically defer until those payments come in – but without losing sight of them, since they’ll come up again on next week’s review.  If that’s not possible, you can try to chivvy the partners into doing some of the billing they’ve been promising to do – especially if you can identify files where you’re holding monies on client account which you can properly bill against.  If things are really going wrong, it will also give you the chance to warn the bank manager in advance that you may be running close to your limits – the bank will always be much more sympathetic if they know you’re on top of the situation and give them advance warnings, as against their noticing from their morning lists that you’ve gone over your limit without saying anything about it!

One of the things that seems to be getting out of control is disbursements.  We just don’t know how much we’re paying out.  It seems to be a never ending drain on the account.

One of the things that will be making that worse for you is the increased level of personal injury claimant work you are doing.  The working capital requirements of such work, in terms of the staff costs of doing work which you are only going to get paid for in a year or two’s time, added to the increasing expectation that firms will act as bankers for their clients against a background of hefty rises in court fees etc., means that only those with long pockets will survive.  I even know of one firm where they spun their PI practice off into a separate firm, as the working capital levels were so high it was putting potential new partners off the idea of joining the firm at all.  But there are some controls you can introduce.

Like what?

The first thing is proper disciplines for incurring disbursements.  Each type of work you do should develop its own rules as to which disbursements can automatically be incurred; which need specific authority; which cannot exceed set limits; and which can only be incurred if the client or a third party provides funding up front.

Then there is the full use of a disbursement ledger.  That means that whenever you incur the debt for a disbursement, it goes straight onto the ledger system, even if you haven’t yet been billed for it, never mind paid it.  That will give you a real figure for the indebtedness of the firm – and, incidentally, it’s the only way of properly complying with the requirement to keep estimates for clients up to date.

Then, when disbursements are paid, they can be identified and aggregated by department and / or for the whole firm, so you have overall figures and can see just what the extent is to which you are becoming your client’s bankers.  You may find that leads you to seek separate facilities for disbursement funding – there are some lenders who specialise in that.  And, of course, you can then feed that information into the regular reviews that I mentioned earlier.

Thanks for all that.  If I can that established, I guess we shouldn’t have such a nasty shock in future?

Quite right, you shouldn’t – but it won’t solve the problem if the basics aren’t right.  Get your partners and fee earners to bill fully and promptly, using interim billing opportunities as much as you can; make sure your collection systems are robust; and avoid being your clients’ bankers, and you might just find the overdraft going down for a change!