Small to medium-sized UK law firms are enjoying a sustained period of economic recovery, but face new challenges arising from renewed growth, according to a major study examining a wide range of performance indicators.
Meanwhile, the research found firms hold more than £1.5bn in client funds, prompting a warning that the cash will be a magnet for criminals.
The third annual RBS/NatWest financial benchmarking report found that both fee growth and profits were up significantly in 2014, although some firms were stretched to meet higher levels of instructions and profit margins overall were flat.
As last year, the report found widespread optimism for the year ahead. Eight out of ten firms surveyed believed their fee income would continue to grow in 2015 and around seven out of ten thought profit levels and chargeable hours would increase.
But many firms feared cash flow challenges associated with lock-up, with more than half lacking confidence that work in progress (WIP) and debtor days would improve.
Steve Arundale, head of professional services at NatWest and RBS said: “Improved revenue and profit levels are welcome but profit margin overall remains flat, suggesting that improved efficiency was not a business focus in 2014, with many firms stretched and challenged to cope with increased instruction levels.
“It is key that firms manage their business processes to become as efficient as possible in order to maintain or improve profitability. Firms need to be better at protecting themselves against the revenue peaks and troughs that are influenced by shifting economic conditions.”
The research was based on financial results from 339 firms with revenues of less than £35m – almost 40% of them with fees of under £1.5m – with a combined income of £1.14bn and combined profits of £288m. It was written by Robert Mowbray, an accountant well known for advising law firms.
Between 2013 and 2014, median fees grew by 5%, higher than inflation and up from last year’s figure of 3%. The report suggested a change in mindset was needed in the new economy, from one of cost-cutting to an approach that focuses “more on the growth of fee income to increase profits” which “may require a firm to spend more on fee-earners and on supporting overheads”.
Mr Mowbray observed that “it is amazing how many firms focus too much on fees and not enough on profit”. Median profit per equity partner (PEP) was £107,000, £20,000 higher than last year, although median PEP in small firms (under £1.5m fees per year), at £71,000, was less than half of the median figure at large firms (over £1.5m fees), £148,000.
A good firm should make 33% PEP as a percentage of fee income, he said. The survey found the upper quartile score was 33%, the median figure was 24% and the lower quartile 15%, compared to 31%, 23% and 12% last year. The median margin for all firms, small, medium and large, was constant, showing “the size of a firm is irrelevant to its ability to make profit”, he said.
Also on profits, the survey found median gearing, which last year was 2.88 – meaning each equity partner was managing 1.88 fee earners – had increased by almost a fifth to 3.41. Mr Mowbray observed: “As work volumes pick up, many firms will need to focus on getting this variable back up to a more sensible figure as clients are not going to be willing to pay a partner to do the more routine work that needs to be done on a file.
“The figure should not however be increased until everyone is working at capacity as it is always better if additional work can be resourced with the existing fee earners, before recruiting new people.”
The report found that just the firms surveyed were holding over £1.5bn in client deposits. Mr Arundale warned that while risks associated with the economy had diminished, the risk of criminal activity harming firms had increased.
He said: “Criminals know that legal firms carry large cash positions via client accounts. This represents a great opportunity for criminals to try and compromise a firm’s security arrangement in respect of their electronic payment governance.”
On staffing ratios, Mr Mowbray pointed out that while firms employed fewer secretaries, they had had to recruit more staff in business development, IT, and other management roles, meaning there were still a similar number of fee-earners as support staff. But he commented: “This is very different to large accountancy firms, where fee earners account for 75% of the total head count.”
Median lock-up was 109 days, up slightly from 107 days last year, although the range was 77 days in the lower quartile and 153 days in the upper quartile, with larger firms finding it harder to manage lock-up than smaller firms.
Firms were cautious about carrying debt and the median bank balance was £56,000. The median firm would run out of cash in 40 days if they received no further money from clients.