Liquidity means different things to different law firms, but the bottom line is that law firm managers and principals must be across myriad factors affecting cash-flow or face the prospect of quickly emerging financial problems, writes Rob Knowsley.
There are many management challenges that confront small- to medium-sized law firms, and during my 45 years in the profession poor liquidity has been one issue that all too often rear its ugly head.
Liquidity simply refers to having the money to pay what the firm needs to pay, when it is due. Note that very often a firm does not regard what it ‘needs to pay’ as including principals’ proper salaries (not mere subsistence drawings). For the record, principals should be viewed as key employees, and paid in full on time like everyone else. To not do so is to manipulate liquidity.
Don’t get me wrong. Liquidity may need to be manipulated from time to time, but on a long-term basis if a firm can’t pay all working employees fully on time, including principals, it has to take a really hard look at its business model.
Two trains of thought
Some firms may take a view that profits should be drawn only when cash is very strong, and others may take the view that a level of profit over and above salary should be drawn regularly, utilising any necessary resources, including an overdraft facility.
There are good arguments in support of each approach. My view is that really special efforts are needed to generate good, real profits, and to convert them to cash. Paying out before the process has been fully completed can mislead some principals into thinking they have done everything they are expected to do, when that may be some distance from the reality!
Of course, normal ‘paying out’ needs to be done very regularly, and sometimes unusual causes of payments also arise, such as paying out a notice period on the departure of a staff member, or payment of a contribution on a professional indemnity claim.
These can be non-elective, or elective – such as a chance to save funds by making an opportune purchase while there is a really good deal available. Elective spending has to be considered in light of the opportunity, balanced with the imminent need for funds for non-elective obligations.
Cash-flow in, on the other hand, tends to be much less regular. When it is not managed properly, liquidity problems can arise even when outgoings are not unusual!
Stress test
Liquidity problems cause all sorts of stresses, including creditors being paid late, staff being paid late, various payments to the Tax Office being paid late, and salary and profit-share drawings for owners being reduced or deferred altogether. GST, wages tax withheld and contributions of employee superannuation are early sufferers in firms as liquidity deteriorates.
Owners may even be required to use personal savings, or personal borrowings, to inject further cash into the firm to improve liquidity. When situations are very poor, the ability to rob ‘piggy banks’, or obtain loan funds from normal commercial lenders, can disappear.
If all the significant factors affecting cash-flows in each direction are not well understood, and managed well, liquidity problems can arise remarkably quickly. Oddly, experience shows this often happens soon after a period where the firm’s liquidity seemed to be going along very well, with full drawings, everything paid on time, and any overdraft facility available not being utilised at all. Far from being heavily into its overdraft, the firm may even have had funds in credit in the relevant facility.
Complacency risk
Very few small- to medium-sized firms prepare regular cash-flow statements. In many of those that do, they are seldom detailed enough and soundly enough based in all vital data to be really useful.
Anecdotally, principals seem to take their eyes off many of the important factors that can very easily have an impact on cash-flow at times when things seem to be going well. Invoicing at the earliest appropriate time, and ensuring that funds are transferred from Trust immediately, is a simple example of things that can be let drift when the firm is coasting along.
Close attention to ALL factors affecting cash-flow and liquidity needs to be commonplace, and consistently done properly. This can help ensure the early warning signs are there right in the face of principals and key managers – far enough ahead for effective action to be taken, and taken early enough, to avoid the foreshadowed problem actually eventuating.
Often, lawyers react very emotionally to poor liquidity, and that is understandable given the stresses it can create. However, in fixing the problem, careful analysis and focused action are greatly preferred to angry and emotive reactions and blame games.
A phenomenon I observe is principals ‘venting’ about poor cash availability, getting the anger and frustration out, and planning to take some important steps immediately, but actually doing absolutely nothing of any real value! Forewarned is forearmed, but, to continue the metaphor, shouldering arms to any degree at all is simply not an option.
From time to time, I also encounter lawyers talking about needing more ‘working capital’, but it should be noted that good liquidity and good working capital are not one and the same thing. Working capital refers to current assets, less current liabilities.
A practice with good working capital may have poor liquidity from time to time, and a practice with very little working capital (that is, no significant gap between current assets and current liabilities) may often have liquidity that is fine for its needs!
Obviously, an overdraft facility can be a very useful resource in managing liquidity, and it needs to be big enough that, when coupled with other sources of funds, there is the capacity to operate without undue stress, and to ride out the wave-like pattern of cash flows.
It is often suggested that at least twice a year the overdraft facility should not be needed at all. In contrast, many firms are constantly at, or even above, their overdraft limit. This is stressful in itself in the short term, but it can also rack up many demerits with the monitoring algorithms used by financiers to determine credit ratings. How much over? How many days over on average? How many times a year?
A further comment on overdraft size is that as firms increase in size and revenues and expenses, principals often complain to me that they can’t understand why the bigger, more profitable, firm needs such a big overdraft, or any overdraft at all.
Each firm has different financial dynamics, but it stands to reason that a much bigger firm can have much bigger fluctuations in its cash-flows, and that without an overdraft limit of sufficient capacity, poor liquidity can confront managers very quickly.
At a loss
Finally, another anecdotal observation …
Periodically, I am asked by a principal: “Why does the firm’s profit-and-loss statement look good, but there is never any cash? Often, the answer lies in the fact that there are almost always items in a firm’s financials that impact liquidity but do not appear in the P&L. Simple examples would include principal amounts that are paid off loans, or amounts spent on capital items. Tax payments made on behalf of principals, or other payments made directly that are not expenses, will impact liquidity but not the P&L.
The bottom line? Cash is indeed king and queen, but if it is applied on your behalf at your direction, without you observing yourself handling it in and then out again, you clearly cannot assume that it hasn’t ever been ‘available’!
