Fee-earners “generate little profit” for SME law firms

Profit: Tiny improvements in billing and recovery can make major difference

Just under 90% of fees generated by fee-earners at small and medium-sized law firms last year were used to cover their costs, Law Society research has found.

The survey recorded that, on the whole, 2019 was a “very positive” year with fees up, staff and partner numbers on the rise too, and WIP and debtor balances are down.

“However, there are indications that some firms are struggling,” said the Law Society’s law management section. Pressure to raise salaries has resulted in firms’ overheads growing more quickly than fees, leading to the first reduction in net profits per partner that we have seen for quite some time.

“This needs to be addressed quickly, as future investment in a firm and its people is only possible if fees and profits are growing.”

Some 214 firms took part in the section’s annual benchmarking survey, conducted by accountancy firm Hazlewoods using their accounts ending in 2019. The full report can be downloaded here.

They were made up of 75 firms with turnovers of up to £2m, 68 of £2-5m, 41 of £5-10m, 29 of £10-35m and one larger than that. All the figures cited in this article are the median unless otherwise stated.

It calculated that a firm must generate £109,379 per fee-earner before they contributed any profit. This was made up of fee-earner cost (including notional salaries for equity partners) of £52,027, support staff cost per fee-earner of £21,697 and non-salary overheads per fee-earner of £35,655.

Working on an annual average of 1,100 chargeable hours, this equated to an hourly cost of £99.94, or £497.18 a day.

With fee income per fee-earner in 2019 at £122,487 – a figure that only rose marginally from 2018 and just £8,000 in a decade – just under 90% of fees earned by a fee-earner were used to cover their costs.

Put another way, in a calendar year, it took until 22 November for a fee-earner to earn sufficient fees to cover their total costs for the year, and for the practice to reach what the survey called ‘super-profits’. These are partners’ net profit less notional salaries and notional interest on capital.

Hazlewoods stressed the importance of all fee-earners recording their time. The survey said: “In our experience, fee-earners in many practices do not fully time record. This is often the case where the work is fixed fee, for example in residential conveyancing. Even where fee-earners do time record, it is rare to see fee-earners recording more than four chargeable hours per day.

“If you do not know how long it takes a job to do, how will you be able to tell if it is profitable and therefore worth doing at all?

“If fee-earners are making the decision to not record all of the time they have taken on a matter, you also risk a further reduction being made at the point of billing, or ‘double discounting’. The fact that it is felt not all time can be recorded suggests that work might not be being performed at the right level, further training is required, or there are undue pressures from management.”

The authors also illustrated how tiny improvements in billing and recovery can make a major difference to a firm’s bottom line.

“For example, let’s assume a practice with 20 fee-earners, all with an hourly charge-out rate of £175. Fee-earners record an average of 1,100 chargeable hours each per year, and recover (i.e. bill) 80% of the recorded WIP value, resulting in total fee income of: 20 x £175 x 1,100 x 80% = £3.08m.

“If the fee-earners are able to increase the recovery rate by just 1%, annual fee income and profitability will increase by £38,500. If the fee-earners can improve productivity by 1%, then this gives a £30,800 increase in turnover and profitability.

“A 1% improvement in productivity represents just one additional six-minute unit per fee-earner per day. A 1% improvement in both productivity and recovery increases income and profits by almost £70,000.”

Other findings included:

  • Practice fee income increased by 5.1%, with most work types seeing a rise;
  • Fee income per equity partner was up 8.6% to £742,069;
  • The ratio of fee-earners to equity partners has increased to 6:1;
  • Total year-end lock-up days (WIP and debtors combined) fell by five days to 142;
  • Equity partner capital (combined total of capital account, current account and tax reserves) rose by 12.2% to £219,691;
  • Net profit per equity partner (before notional salary) dropped 3.7% to £155,897;
  • When this figure was adjusted to include a cost for equity partners, and also notional interest on partner capital, the ‘super-profit’ for the year was £61,878 compared to £69,610 in 2018. A sixth of participants reported a ‘super-loss’ for the year, fewer than in 2018.

The survey recorded a 4.7% increase in fee-earners, which indicated optimism for the future. However, this was set against only the marginal increase in average fees per fee-earner – and actually a 7.3% reduction for the largest firms.

“A reduction in fees per fee-earner could suggest that new joiners are taking a long time to bed in, or that work is being performed at the wrong level,” it said.

The survey found that the net profit margin has also fallen, from 22% to 21.7%, mainly as a result of increasing staff costs. The reduced margin was “particularly pronounced in the smallest and largest firms in the survey”.

Fewer than one in five participants reported that they operated with no overdraft or borrowings at all.

“Banks continue to view the legal sector positively overall, although there is an increasing reluctance to lend to firms specialising in areas such as personal injury or clinical negligence work, where very high levels of WIP and disbursements often result in corresponding high levels of debt,” Hazlewoods reported.

“As per last year, we have seen considerable levels of new lending, secured by a debenture over the firm’s assets only, where performance and debt to equity ratios support it.

“We are also seeing increasing pressure on some firms to bring overdraft levels down, or convert all or some of the balance to debt.

“Many banks pay close attention to the ratio of borrowings to fee income when assessing ability to make repayments, and it is pleasing to see a median of 6.3% for the firms in the survey, compared to 6.5% a year ago.”

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