Here’s Why The Cash Suddenly Disappears In All Too Many Small Law Firms…

KMSProfitPower™Tip: Other than in headlines, cash doesn’t “suddenly” dry up.

Rather, the way owners organise (or fail to organise in key respects) the practice in its trading usually lays down the recipe for an inevitable problem.

A mix of causes in day-to-day operations prevents sufficient value being created in potential future cash, and because few small law firms prepare cash flow statements (let alone fairly accurate ones) the fact that insufficient cash is going to be flowing inwards is “hidden” from owners until the early pain points occur.

This is usually the point where different degrees of panic set in.

Most expenses in small firms are fixed, so the outward flow of cash continues despite not being met (let alone exceeded) by inward flows, and cash reserves are reduced, clearly demonstrated in the first graph below.

In this example I’ve depicted a firm that began the trading period with a cash reserve of $100,000 (it could just as easily have had no actual cash reserves, but, for example, an overdraft facility of $100,000 unused at the beginning of the trading period).

The numbers used show, in the blue columns, a budget that, if met, would deliver the two hard-working owners a sound commercial remuneration of $200,000 each (similar to what they could have earned working for another firm with no risk), and a super- modest true profit of $16,000 each (N.B. Less than 0.1% of revenue)!

The opening cash reserve would almost certainly have fluctuated over twelve months of trading in line with typically fluctuating productivity and credit management performance, but assuming no profit drawings were taken, the reserve would have grown to $132,000 by year-end. I’ve depicted revenue and expense flows as stable every month for simplicity.

Further, I have not included in this example cash being used to reduce principal on loans, small capital purchases etc.

Contrast that situation to the very different cash position if revenues failed to reach budget projections by as little as 5%, and expenses averaged 2% more than the budget projections. In my experience that is a very typical scenario, and it is often much worse.

The orange columns in the graph depict the cash reserve being heavily eroded from month one, and it is completely gone, or overdraft facility exhausted, by the end of month 6.

To battle this typical problem owners need to be focussed on ensuring that utilisation of people resources is at least at budget levels throughout the trading period. Further, it’s important that budgets are set wisely so the full opportunity for revenue generation is at least available to the firm. This is the “building blocks” area where most firm get the planning badly wrong.

At best this critical need must be tracked daily because once bubbles are created in the revenue pipeline they are extremely difficult to recover from, and there are precious few small law firms where proper utilisation is not a very significant impediment to proper profitability.

A firm with:

·       sound business development processes,

·      good monitoring systems for new enquiries and new matters, generation of work in progress, and invoices,

can operate reasonably successfully with high quality monthly reporting, but the right sets of financially literate eyes must not be taken off the key balls in the air for any longer without a high risk of very stressful consequences.

The second graph below shows what so often happens in small firms, which is that owners stop taking a proper salary in an after-the-event attempt to conserve cash. Here I’ve assumed that owners’ salaries are reduced by $100,000 each to maintain the ability to pay staff and meet all budgeted expenses.

Ironically, in many firms the owners will still be getting given accounts that show the owners are generating trading profits, despite being unable to pay themselves more than 50% of a commercial salary.

The next graph shows in the green line how so many firms manage limited cash by restricting owner salaries. The cash reserve at the beginning of the period is still dropping slowly, but of course nothing like the situation if the owners were being paid proper salaries at the same time as employees (the orange line).

The day of reckoning is coming, with little or no understanding of how to fully rectify the problem. Of course, should there be further deterioration in collected revenues, unexpected and unavoidable increases in expenses, or necessary capital outlays not budgeted for, the cash disappears just that much faster.

It’s in this zone that some serious problems can arise, with things like escalating debts to tax authorities and staff superannuation entitlements not being met on time.

If further borrowings are available it needs to be fully recognised by owners that they are not a long-term solution. The fundamental deficiencies embedded in trading must be understood and addressed so a model is created in which trading produces genuine profits after properly paying owners, cash flows properly, and all expenses and capital obligations can be met on time.

Robservation: When budgets are prepared in small law firms the level at which owners regard people resources as being “properly utilised” is very often way too low.

Very significant daily waste (valueless time) is built-in to the calculations, and because the true profit margin is so low in the budget (in our case above, an excruciatingly small percentage of $3.6M budgeted revenue), the margin for error is small to non-existent.

Disappointingly, in trying to get revenues up, owners tend to focus on traditional areas in looking for improvements, which will be in small increments at best.

By all means get those things right…pricing, realisation, and collection, but in doing so don’t overlook where the game-changing gains are to be made, in proper utilisation of the whole working day of direct fee-earning team members.

Done sensibly, with ongoing careful attention to detail, there is no need for small law firms to have ridiculously small true profits…and to teeter on the edge of cash flow disasters for large parts of every trading year!

Because margins are so small in many law firms, quite small increases in collected revenue will have a powerful multiplier effect on true profit. For an easy to calculate rule of thumb, at the bottom end of the potential range of improvement, think 1% extra revenue without expenses increase and 10% profit lift.

I’ve not encountered any firm in the last 37 years consulting that couldn’t achieve that easily with a simple revision of its approach to planning utilisation of human resources.

But there is always a lot more blue-sky opportunity available.

Consider a fairly typical small firm:

Scenario 1:

Revenue of $1,000,000

Expenses of $770,000 (77%) before the sole owner's salary $200,000

Owner’s salary $200,000

True profit $30,000 or 3% of revenue

Scenario 2:

After improved utilisation…

Revenue lifted 10% to $1,100,000.

Expenses (no change other than including consultant’s advice) $789,400

Owner’s salary $200,000

Owner’s true profit $110,600 (approx. 10% of revenue…increase $80,600 or 3.367 multiple).

Robservation:

There’s never a bad time to recognise that a business you own isn’t operating with genuinely sound fundamentals. April 2025 is by definition a good time to reorganise the firm along sensible businesslike lines, particularly so with more heavy disruption coming from firms that embrace AI.

To be able to establish good profitability, and benefit from the excellent flow of cash that will deliver, requires some basic sensible changes now.

As the tsunami of change continues for the profession, to be in the cohort that survives and goes on to be financially healthy requires well-guided action now.

Lots of people are depending on the right decisions being made, with successful systems adopted and adhered to through thick and thin.