1,000% interest income rise masks profit falls at SME law firms

Interest: Temporary boost

Interest income at small and medium-sized law firms surged by 1,000% last year, research for the Law Society has found, masking a significant fall in profits.

It also warned that some banks had been “hit quite badly” by law firm failures, including the collapse of Axiom Ince, damaging confidence in the legal sector.

Accountants Hazlewoods, which studied the fortunes of 147 law firms for the society’s annual leadership and management section financial benchmarking survey, said there was “a very steep increase” last year in interest received by firms on money held in client accounts.

Total net interest income across the firms, more than two-thirds of which had turnovers of under £10m, rose from £2.6m in 2022 to £27.5m in 2023.

“However, this comes with a warning that interest income is likely to be a temporary bonus, rather than a sustainable element of profitability,” the society said.

If interest income was removed from the 2022 and 2023 profit per equity partner (PEP) figures, PEP would have fallen by 7.85% last year rather than the final figure of only 0.7% – from £211,204 in 2022 to £209,650 in 2023.

“Because of uncertainties around how long the current high levels of interest will remain, we would view this as a more realistic measure of the fall in sustainable trading PEP across firms,” researchers said.

Over recent years, some banks had been “hit quite badly by law firms falling into administration, and so confidence in the sector generally remains below where it has been in the past”.

The report went on: “These issues have unfortunately continued, including the very high-profile collapse of the Axiom Ince Group and negative press that has surrounded the circumstances of the collapse, and so it seems likely that enthusiasm will remain muted, at least for the time being.”

Law firms were advised to remember that “many banks pay close attention to the ratio of borrowings to fee income when assessing a firm’s ability to make repayments”, so it was encouraging to see that the median ratio had fallen from 7.7% in 2022 to 5.4% last year.

Researchers said most firms that took part in this year’s survey had either a 31 March or 30 April financial year end and as a result, the findings “represent the first full year of many of the challenges currently facing firms, such as high inflation, increased bank base rates and record energy prices”.

Median chargeable hours across all firms fell from 816 to 793 hours last year, against the 1,100 figure used as a rule of thumb by many firms. Median spend on non-salary costs per fee-earner increased by 13%. In all, 89% of fees earned are used to cover a fee-earner’s costs.

Put another way, for a firm with a 31 March year-end, the average fee-earner only becomes profitable from 18 February.

The Law Society said: “It is unclear from the survey why chargeable hours are so low – whether this is informed by cultural issues around time recording, an increase in non-chargeable obligations (such as training, business development and admin) or something else.”

Median fee income was up by 6.8%, however, with income per equity partner up from £1,024,000 to £1,124,000.

In terms of future growth, confidence was “fairly high across firms in most turnover bands”, with a median prediction of 3.7% growth in fee income for 2023/24.

The smaller firms with turnover below £2m were “less optimistic”, forecasting a median reduction of 2.8%.

At the same time, a fall in gearing (the ratio of fee-earners to partners) fell from 7.7:1 to 6.8:1, the opposite of what usually happens during periods of growth.

Nick Emmerson, president of the Law Society, commented: “Although law firms are proving to be financially strong and resilient, we live in tough economic times… Despite costs rising and billable hours decreasing, profits have only marginally declined.

“The legal sector remains healthy, continues to be an important driver of the UK’s economy and a significant employer. In fact, the overall number of people employed by law firms has risen even if the lack of government investment in legal aid is hitting some firms hard.”

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