Improvements to Law Firm Practice Management
The ALPMA have released the results of their annual benchmarking study of Australian law firms.
Law firm practice management is a key focus in profitability, working capital and overall law firm valuation.
While I concentrate on small law firms, the interesting thing to me is that the average profitability is low in all revenue categories.
For example in the annual revenue category of $5- $10 million and $10 to $20 million, profitability is 8% of revenue. This is the same as the less than $5 million category.
The study used a notional salary for principals of $200,000 in metropolitan areas and $150,000 in regional areas, so presumably the 8% profit is after deducting that.
If I were to allow for fees per principal of $1 million (of course many firms will be less than this) then 8% represents just $80,000 pa average return on investment across these categories of practices.
So what does that mean for practice valuation?
This is indicating an average income for a principal of at best $280,000 p.a. and a regional practice of $230,000 p.a.
While those figures may seem OK at first glance, when valuing a business, the most common way is to calculate an appropriate return on the return on investment (ROI)
In other words, that profit figure of $80,000 at say a 40% ROI, would give a practice value of $200,000 per principal. Based on $1 million in fees per principal, this would reflect a goodwill value of just 20 cents per dollar of fees.
If you think that 40% ROI seems too high, a typical accounting practice may sell on 30% and they are usually valued much more highly by the market, so I’m probably being generous.
What about working capital?
The figures for the amount of working capital (Debtors and WIP) tied up in practices are way too high across the board. The larger firms have around 160 days of working capital.
In English, what that means, is that on average from commencing a matter, to getting paid, it is taking around 160 days, or over 5 months!!
For a practice with annual fees of say $5 million, on average, their working capital could be around $2.2.million!! That is a serious bank overdraft, if that is how it is being funded.
Does size matter?
What this suggests to me, is that the larger firms in the study, with presumably more resources at their disposal, are not able to achieve any worthwhile advantages over small law firms in respect to profitability or their use of working capital.
This study indicates that being in a larger practice potentially offers little in the way of financial advantages and all the disadvantages of being trapped in a large organisation.
Can small firms make great profits?
If you run a small practice, rest assured that the answer is a resounding yes!!.
I know many small firms don’t, but most have enormous potential to substantially lift profitability.
What would I define as great profits?
I think anything over say $400,000 per principal is a reasonable return for the skills and stresses involved, let alone the time and money invested in the practice.
Many small firms are either making this sort of return or certainly have the potential to, if they improved their practice management.
Law firm practice management is a key focus in profitability and overall law firm valuation.