Working Capital Needs for PI Firms

Working Capital Needs for PI Firms

Few lawyers (whether partners or employees) have much conception of what it costs their firms to carry out the work they undertake.  Their focus is on the legal work required of them by their clients.  They will demand the resources to do the job, but will regard time recording as at best a tedious necessity, and at worst an option.  If the management is lucky, the lawyers may get around to billing the matter when completed.  They will however expect prompt payment of their salaries or drawings, come what may.

What they will seldom do is to think about what it costs to do the work they undertake, i.e. what the working capital requirements of the firm are.  The two elements of that working capital are work in progress (WIP) and unpaid bills for fees and disbursements (debtors).  Those are the unavoidable elements that the partners have to fund, to cover the period when the financial return from the work being done is unrealised, i.e. what is referred to as ‘lock-up’.  (For many firms there may be an additional complication, if disbursements have been incurred, or worse still paid, without any cover and without being billed)

Recording the data

From a managerial viewpoint the benefit of time recording is to establish a true picture of the cost – not necessarily the chargeable price – of work undertaken by the firm.  WIP is a cost.  It is the expense to the firm of producing an asset, i.e. work, which has not yet been sold.  In the context of a professional service firm such as a law firm, there is no initial acquisition cost of the asset, merely the cost of the work.  Hopefully, the asset created will be sold for more than its cost, but that may not be the case.  The work done may not be fully recoverable, e.g. because the cost of the work in a fixed-fee matter exceeds the amount which can actually be charged.  The principle of valuation is that it is the lesser of the actual cost, and the realisable value.  (Note that the actual method of valuing WIP may be altered by a recent amendment issued by the Accounting Standards Board to FRS 5 which (if adopted by firms) looks set to increase values.)

Debtor records are more likely to be accurate, but even this may not always be the case, e.g. if ledgers are not properly cleared at the end of a matter.

Data as to levels of lock-up is commonly presented in terms of so many days’ worth of WIP, or debtors, or overall lock-up.  In each case the formula is the same, simple one.

Take the total of the element under consideration, divide it by the firm’s annual turnover, and multiply by 365.  Thus, a firm with WIP of £200,000 and annual turnover of £800,000, would give the following result:

WIP         (200,000)
Turnover (800,000)        x 365 = 91 days

The advantages of this approach are that
·    it makes it very easy to identify trends
·    it gives a clear picture of the overall situation, and limits the ability to disguise bad news (e.g. it is no good seeing the WIP days drop, if the consequence is that the bills are in fact being presented too early, and the debtor days go up correspondingly, so that the overall days of lock-up remain constant)
·    it enables firms to benchmark themselves against others, as considered below.

Benchmarking

Benchmarking is a test of various aspects of a firm’s performance against that of its peers.  The exercise may draw attention to areas where performance is better than the norm, in which case management can try to identify the factors which are contributing to that success in order to develop them further; or it may show it to be behind the game in certain aspects, in which case management should identify what the causative factors, in order to reduce or do away with them.  

When using benchmarking data, care needs to be taken to ensure (so far as possible) that
·    the data is current
·    firms of a comparable size are being profiled
·    the compilers have adjusted for different accounting methods
·    firms are of a similar nature (i.e. not mixing City and provincial firms)
·    firms have a similar worktype profile

Funding the working capital

Acceptable levels of lock-up cannot be considered in isolation.  Lock-up is one part of the mix of the firm’s overall funding requirements.  It therefore needs to be seen in the light of other capital requirements, for instance the capital funding needed for the ever-increasing burden of financing the I.T. spend of the firm.  In particular, a balance needs to be struck between the amount of partners’ own funding which is used for the aggregate requirements of the firm, and that which is borrowed.  On the one hand, partners will probably wish to keep their own investment to a low figure, as there are not only difficulties in finding the money in the first place, but also a burden put upon succeeding partners if the balances they have to pay out to retiring partners are too high for their cashflow to cope with.  On the other hand, lenders will wish to see that the parties are committed to their own business, and will expect that to be reflected in capital invested.

There are no hard and fast rules, as firms’ needs will differ, as will lenders’ approaches, but a rule of thumb would be that partners’ aggregate funds should at least match borrowed funds, and that available partners’ capital should be enough to cover something between three and six months’ running costs for the firm.

An extract from the survey carried out by BDO Stoy Hayward, for the LMS, illustrates some of the information which can be derived from benchmarking.  (All figures exclude VAT, and are in £000s.)

Firm size (no. of partners)    Disbursements    Outstandingprofit costs    Work inProgress    Total
2 - 4      17      67      124      208
5 – 10      52    217      612      881
11 - 25    113    556    1565    2234


It is impossible from the data to be precise, but it would appear that the average per partner is thus something in the region of £50,000 to £100,000.

The general approach

The firm’s management, when lock-up is considered, must make sure that those within the firm understand the importance of reducing the overall levels, i.e. that people recognise the benefits of there being the shortest possible time span between doing a piece of work and receiving the money for it.  The firm’s business planning must recognise the capital consequences of the choices enshrined in it.  For instance, if a firm is going to concentrate on personal injury and medical negligence work, it needs to be aware that although the prospects of being paid at the end of the day are good, the nature of the work means that there is likely to be a long period between work being done and actual payment being made.  The firm needs to be sure it will have the capital reserves to cope with that.

There are of course also practical steps which they can take.   These should include
·    Having an adequate system to check, when new clients and / or new work come the way of the firm, that proper consideration is given to any credit control risks that there may be, e.g. because the work is speculative, or the client’s credit worthiness may be suspect – and do not be afraid to turn work away if there are apparent problems.  
·    Using fully the cost limit warning systems that most computer installations will provide.  ‘Flags’ should be set so that they are genuine early warnings, not merely an afterthought when the limit has already been reached.  
·    Routine monitoring of time records to query why abnormally high levels are being recorded, either
o    on a particular file, when it should be capable of being billed on an interim basis, or
o    by a fee earner, as an indication of a failure to close files off and to bill them
·    Providing where acceptable a system to ensure that disbursements are normally neither paid nor incurred without a partner’s prior approval.
·    Using the firm’s I.T. systems to tell department heads or supervisors when no action has taken place on a file for, say, a month, as it may be ready to be billed.
·    Having a robust system for reminders / statements to be sent to clients.
·    Making debt collection procedures, for unpaid bills, the rule, not the exception.  If special treatment is to be given, it should be agreed by an uninvolved partner.
·    Being hard-nosed about stopping work for clients who do not pay, either where an interim bill is unpaid but there is further work to be done on the file; or where the firm is handling multiple matters for the same client and one or more bills are outstanding.  


The particular problems for personal injury

A stark illustration of the lock-up consequences of various types of work, highlighting the problems faced by firms in the personal injury world, is the following chart drawn from the LMS’ survey’s information:

 
Using the rules to minimise the PI problem

There are no doubt many drawbacks to the Civil Procedure Rules, but equally they do confer a number of useful weapons in the credit control armoury, i.e. they offer the claimant personal injury lawyer a variety of opportunities for maximising and accelerating payment of the costs due.  A number of instances are set out below.

Summary assessment (CPR r44.7)

The Court should always consider whether to make summary costs orders in all cases which are either fast track or last less than one full day, and the advocate should make sure that this is done.  The fact that a CFA is involved is not of itself enough to displace the presumption that this exercise should be carried out.

Time for payment (CPR r44.8)

This is reinforced by making sure that the time for payment is observed, under penalty of interest on default.  There are 14 days only for payment to be made once an order is made.

Implied order where part 36 offer accepted (CPR r44.12)

Where a part 36 offer is accepted (whoever made the offer) an order for payment of costs is automatically deemed to be made, and the defendant’s liability for interest on costs runs from that date.  Negotiations as to amount should begin immediately.

Costs only proceedings (CPR r44.12A, 45)

Many will not hesitate to issue such proceedings, but get them on foot as soon as possible to take delaying tactics out of the defendant’s hands.  Such proceedings may now lead to fixed costs claims in RTA cases under Part II of Rule 45, if the damages do not exceed £10,000.  The success fee to be awarded in such cases, where appropriate, should now be capable of being known in most instances.  The attraction of taking fixed recoverable costs is reinforced by the provision that, even if the Court agrees (exceptionally) to assess costs, and assesses them at a higher level than the fixed amount, the lower of the two will still be ordered unless the assessed amount exceeds the fixed sum by more than 20%.  

Fast track (CPR r44 PD Sections 15 & 16)

Where a compromise is made so that the unagreed residue is less than the fast track limit, and the case is then allocated to the fast track, all the costs down to that date may be ordered by the Court.  Similar provisions apply where what has been a small claims case is allocated to another track.  

Filing detailed assessment claim (CPR r47)

The claimant’s lawyer should always try to get the bill dealt with as soon as possible after the conclusion of the case, and should not allow negotiations with the paying party to lead to the (generally 3 month) time limit for the filing of a detailed assessment claim being overlooked.  If it is, then amongst other perils there is the likelihood of the valuable right to interest on costs being partly lost.  Likewise where points of dispute have been served, and the claimant’s solicitor needs to file a request for a detailed assessment hearing, where the same penalties apply.  He or she should consider in such instances whether to apply for an interim costs certificate with its implied payment order.

Securing support

The last leg of the task for management is to secure the support of partners and staff for credit control measures.  This is a matter of culture, and of education.  Partners in particular need to be made to realise how a good control system can directly affect their pockets – and conversely what happens if poor performance in this regard creeps in.  Some firms, in the last couple of years, have found it a salutary – if painful - lesson to have to cut back on partners’ drawings when the cashflow has been poor.  Naturally, managers will want to avoid getting to such a drastic stage, and it must be a more helpful demonstration if, for instance, an extra draw can be agreed because performance has improved.