It is safe to say that workflow has been mixed across the majority of practices. Maintaining chargeable hours has been challenging, but lots of firms are still seeing top line growth, though a big part of this is being driven by inflation.
Whilst fee income has been rising over recent years, including during Covid for many firms, this rise has decelerated, and double-digit rises may not be repeated for the foreseeable future.
Margins have come under real pressure due to increasing costs – especially salaries. There are ‘baked-in’ high pay rises from 2022 and 2023 that are still hurting a lot of firms and rising IT costs continue to be a thorny subject for many. Other cost of living increases such as light and heat, as well as professional indemnity insurance rises, continue to cause discomfort.
It is not all bad news of course, and it feels for many that recruitment pressures are starting to ease, as are salary expectations (or at least salary increase expectations). There is a general acceptance that pay rises will have to be more modest over the next twelve months or so for them to be sustainable.
Interest earned on the client account has really come to the rescue of a lot of practices and so it is critical that firms understand, and monitor, the quality of their profitability. For some, a significant portion of profit is made up of interest earned on client money and that proportion has been increasing. Looking back a few years, the proportion of profit attributable to interest was less than 1%, whereas now we are seeing cases of 50% or more.
Anybody who attended the SRA's Compliance Conference on 5 November 2024, and those who have had a chance to read the SRA’s recently released consultation, will see that the SRA is taking an increasingly dim view of residual balances, suggesting that firms may be deliberately holding on to residual balances in order to enjoy the client interest on that money.
This, of course, means that both the thorny issues of residual balances and interest income have fallen under the gaze of the SRA again and this is a timely reminder that firms need to get a handle on a couple of things:
Don’t forget that the SRA makes the rules and could theoretically restrict, if not remove, the ability for firms to hold onto this income. In fact, the consultation raises this very point. The impact of taking such a drastic course of action may not be in the best interests of the industry, but the wording of the consultation does not give anybody confidence that interest income will be a permanent fixture.
This is therefore a good time for firms to get a handle on what drives sustainable profitability for them. They should, for example, consider whether their fee earner gearing is right and to what extent those fee earners are hitting capacity targets. It should, theoretically, be possible to make incremental adjustments in order to achieve bigger gains, but only as long as all elements of profit generation (i.e. chargeable hours, recoverable rates and overheads) are behaving properly and firms don’t look at stats in isolation.
At Hazlewoods, we look at a lot of financial data across our clients and measure how certain metrics of more profitable firms compare to those not so profitable firms and it is common for better performing firms to be more highly geared. However, it is important that firms do not focus on gearing at the expense of other financial stats and increasing gearing should only be considered once firms are happy that all staff are working at capacity. This can be elusive for a lot of firms.
Understanding the basic level of working capital, and therefore partner capital, requirements in a firm is very important and that is something that we model carefully for our law firm clients.
Being on top of work in progress and debtor management are relatively easy but crucial parts of the financial resilience of any firm. So, for example, the act of setting work in progress targets across departments and sticking to them is simple, obvious but overlooked. Other easy wins such as making sure that bills are raised throughout the month rather than on the last day of the month, can be implemented without too much disruption, but in some cases can eliminate the need to operate a bank overdraft.
Looking ahead now, things remain challenging for firms. Moderate fee growth is predicted across lots of practices and whilst interest rates remain high for now, they have fallen over recent months and that may continue to fall. Firms need to think and act now to wean themselves off interest as much as possible.
While dealing with those challenges, financial stability and the SRA’s approach to monitoring firms may reappear in the not-so-distant future. Any of us old enough to remember the red, amber, and green flags from ten years or so ago, will no doubt anticipate their revival in light of the Axiom Ince collapse.
All said, it is easy to focus on the negatives here but this does not necessarily need to be viewed as such. If firms focus on what they have been doing, but just making sure they are doing it better, then all should be ok. The legal industry has a history or showing financial resilience in the face of adversity, and long may that continue.
