Law firm finances are far from simple. In the early days of your practice, you’ll find yourself dishing out one-time fees, like the costs of business licensing and a new business website. As your practice grows, you’ll incur recurring expenses, from online subscriptions to employee payroll. The type and level of expenses will grow as your firm grows and as you take on new clients and explore new opportunities in the legal field. Once you factor in client invoicing, bookkeeping, and financial reporting, financial management can become significantly more complicated. Fortunately, it doesn’t have to be. This ultimate guide to law firm finances will break down everything you need to know to drive profits and limit expenses for your legal practice.
What Is Law Firm Financial Management?
Law firm financial management involves forecasting, planning, managing, and tracking a law firm’s finances. Law firm financial management activities range from monitoring cash flow to budgeting for recurring expenses and analyzing the firm’s profitability to predict future growth. Following appropriate financial management practices allows law firms to maintain consistent profits and overall practice success. However, to successfully address these financial-based initiatives, you must understand the various operational components that drive an effective financial strategy. Those who have worked in other types of businesses may be unprepared for the volume of financial activities required by a law firm. Not only does financial management for a law firm involve the day-to-day business activities, but it also includes strict regulations that must be followed to protect the firm and its clients.
Six Key Components of Law Firm Financial Management
When it comes to law firm finances, practices must address six critical areas of financial management to support profitability and practice growth. The six key components of law firm financial management include:
- Billing & Invoicing
- Payment Collections
- Financial Reporting & Taxes
With each of these components comes various management, tracking, and forecasting responsibilities to ensure a well-rounded law firm financial management process. Fortunately, with professional assistance and financial management software, law firms can better streamline management needs for increased accuracy, visibility, and practice productivity. Let’s dive deeper into the six critical components of law firm finances to gauge how your current workflows stack up.
Law firm accounting practices are used to analyze, interpret, and summarize a firm’s financial data for various operational needs. Law firm accounting tasks can include:
- Monitoring a practice’s financial performance.
- Analyzing and reporting on financial data.
- Leveraging this data to create financial forecasts and firm budgets.
Though the accounting side of running a law firm may seem a bit complex, managing finances through these multiple practices is critical to maintaining profitability and, more importantly, meeting compliance standards. Law firm accounting differs from typical business accounting and often requires specific approaches to avoid regulatory concerns. Take trust accounting, for example. Law firms may use trust accounts to collect funds on a client’s behalf, but it’s required that the practice holds the client’s funds in an account that’s separate from the firm’s finances. Failure to comply with such law firm finance regulations could result in costly violations and impact professional licensing status. This is an area where every law firm must be fully committed to transparency and accuracy. Whether the firm works with an in-house accountant or hires an accounting firm for its needs, every detail must be carefully considered. If a firm uses an outside accountant, choosing one with a strong history of working with attorneys is often the best choice for security.
Lawyers and paralegals will often consider accounting and bookkeeping as having the same function when discussing law firm finances and the many components that accompany an effective management system. However, bookkeeping is a separate and distinct financial management area required to complete numerous accounting tasks. While accountants are responsible for analyzing, forecasting, and reporting on a firm’s financial data, bookkeepers are responsible for initially recording and managing this financial data. To supply accurate data to accountants, bookkeepers must record client transactions, create and disperse invoices, process payroll, and ensure accounts receivable and payable are correctly balanced.
Simply put, a lack of proper bookkeeping efforts would make it impossible to track how law firm finances are moving in and out of your practice. When navigating law firm financial management, poor bookkeeping will affect your operation in many ways, including but not limited to negative impacts on growth potential, compliance concerns, and even client satisfaction. Additionally, poor bookkeeping can potentially put a firm at risk for mismanagement of client funds, any funds held in trust, and expenses that were miscategorized or mishandled in some way. A bookkeeper who works at or with a law firm should have specific experience in this area and industry to reduce misunderstandings and the risk of regulatory noncompliance.
From office secretaries to the attorney team, practice employees rely on law firm employers to effectively manage company payroll to get them paid on time and consistently. Managing payroll is often cumbersome and time-consuming but this process can become much more efficient with the right financial management software solution. Law practice management software can be integrated with payroll solutions, such as Quickbooks, enabling law firms to streamline and automate their collection of payroll tasks. Payroll tasks that firms can automate include:
- Tracking employee hours.
- Calculating each employee’s pay.
- Withholding necessary payroll deductions.
- Dispersing employee payments.
There are also critical payroll tasks a law firm must complete for tax compliance purposes. To accurately remit the required payroll taxes to the IRS, payroll managers must precisely document and report on employee wages, tips, and other forms of compensation. Failure to follow these payroll requirements could result in tax complications for employers and employees. Once tax complications begin, they can take a long time to sort out, and that can cause unneeded extra stress and strain in an already fast-paced industry. The right payroll software and support personnel are critical, especially for a large law firm with a big payroll.
4. Billing & Invoicing
While it’s a given that billing and invoicing are essential aspects of law firm growth and success, it is, unfortunately, one of the most repetitive and least enticing components of financial management. The invoicing process involves creating and distributing payment requests to clients for your services. Billing efforts can quickly become prone to error due to the repetitive nature of these tasks, which creates multiple opportunities for unwanted write-downs and write-offs. While billing may not seem like an exciting part of a law firm, it is one of the most vital areas and must be handled correctly. Not only does proper billing mean funds are coming into the law firm for services rendered, but it means complying with regulations and guidelines for how much is charged and what services are provided. Mismanagement of client billing can quickly create severe problems for any law firm. A robust law practice management software with time & expense tracking can be highly beneficial for client billing and invoicing purposes.
The use of invoice and billing software can help law professionals implement and manage a variety of client billing models, including hourly rates, flat fees, contingency fees, and retainer fees, to match their firm’s specific needs. With a billing model on hand, a practice can more effectively (and consistently) navigate the steps of client invoicing. Client invoicing includes gathering client billing information, such as name, address, and bill amount. Once this information has been verified, a law firm can create an invoice with invoicing software and pre-made invoice templates to be sent via mail, email, or even through the software itself. That helps ensure that clients are being billed appropriately for attorney services and that bills are going out to the right people and places in a timely manner. It also streamlines the process, which significantly reduces the margin for error and creates a smoother process that minimizes the time law firm billing personnel must spend on this task.
5. Payment Collections
Once invoices have been distributed, the next step in law firm finance processes is to wait on payment collection services to obtain client payment. Because unpaid invoices are an inevitable downfall of operating any law firm, it’s essential first to create a uniform policy that outlines how to deal with outstanding fees. Generally speaking, unpaid client invoices will enter the collections process once they’ve become 30 days past due. When a client fails to submit payment within the expected time frame of receiving an invoice, you should initiate your collections process by verifying that invoice details are correct and that your billing office did not miss that incoming payment.
You can minimize clerical errors and delayed payments with case management software. Case management software lets law firms view all client case details, invoicing dates, and communication efforts from a single location. With verification details on hand, law firms can track repeat reminders and potential payment arrangements as a last resort for payment collection. If all else fails, a client may need to be referred to a collection agency or issued a legal suit warning. Sending a client to collections too quickly can be bad for business, and the reputation of a law firm is one of its most important marketing areas when it comes to bringing in new clients. By automating as much of the payment collection process as possible, your law firm can provide every reasonable chance and accommodation to clients who have unpaid bills before getting a collection agency involved.
6. Financial Reporting & Taxes
As you can see from the above law firm finance components, firms can use numerous pools of financial data practices for financial and tax reporting. While it can be a dreaded and time-consuming process, financial reporting allows you to understand how your business is performing, forecast future growth, and complete necessary tax reporting requirements. To streamline your financial reporting activities, tap into the power of law practice management software to collect, track, and analyze your firm’s income more accurately. Understanding where your firm’s finances currently stand compared to your overall goals can help you make more effective business decisions and operational updates that encourage growth. When beginning financial reporting, your law firm will assess key financial performance indicators (KPIs) to understand your financial standing. Below is a collection of the most crucial financial KPIs every practice should track for top-tier financial reporting and optimal law firm finances.
Eight Important Financial KPIs Every Law Firm Should Track
Law firm finance KPIs measure a practice’s overall growth and success. These indicators are essential to identify operational strengths and weaknesses across your law firm to support a continuous upward trajectory for you, your lawyers, and your paralegals. If you are not tracking these metrics, there is a good chance you’re missing out on opportunities for growth and development for your law firm and new and better ways to improve your clients’ experience. Here are the top eight law firm finance KPIs practices should track:
1. Profit and Profit Margin
Profit refers to the amount of financial gain a practice has earned after all expenses have been paid. A law firm’s profit can be calculated by subtracting all expenses (payroll, rent, utilities, tax liability, marketing) from earned revenue. Using this KPI, a law firm can determine its profit margin, which is the percentage of firm revenue that is retained as profit.
2. A/R Over 30 Days
A/R over 30 days, or accounts receivable over 30 days, tracks the amount of money each client owes for the services your firm provided over the past month. Tracking A/R over 30 days is essential as it aids in better cash flow management and is crucial for recognizing potential collection issues early on.
While A/R is used to identify pending yet inaccessible cash, cash on hand is a KPI used to determine the amount of accessible money available to a law firm after all costs have been paid. Understanding where your cash-on-hand KPI stands empowers your law firm to make more responsible business spending decisions, especially for non-essential expenses.
4. Realization Rate
A law firm’s realization rate measures the percentage difference between the amount of recorded billable hours and the number of hours billed to a client. Realization rate is key to understanding a law firm’s profitability and identifying billing flaws impacting revenue.
5. Labor Percentage
Labor percentage identifies the percentage value of money spent on labor and payroll costs against a law firm’s total revenue over a set period. This KPI is essential to learn your firm’s ability to turn labor into profits and determine the best prices and billing models for your legal services.
6. Revenue Billed per Month
Revenue billed per month is the total anticipated revenue amount your clients have been billed for over a month. This KPI helps law firms understand how much revenue they can anticipate upon client payments and comprehend general month-to-month performance.
7. Revenue Collected per Month
While revenue billed per month identifies the total amount of anticipated revenue being invoiced over a month, revenue collected per month determines the total actual amount of revenue collected and secured each month. This KPI can identify how client collection efforts are performing and gauge your exact cash-on-hand amount.
8. Collection Rate
Law firm collection rate is a percentage KPI that uses revenue collected and revenue bill data to measure how effective a law practice is at collecting client revenue. Firms can use the collection rate to assess the strength of billing efforts and determine the percentage of secured revenue versus pending revenue.
Robust Law Firm Finances Begin With a Basic Understanding of Management
Whether you’re just starting the development of your financial management system or looking to enhance your existing one, it’s vital first to comprehend and address the six essential components discussed above — and the accompanying KPIs — for a well-rounded approach. To best navigate your law firm finances, start by understanding your general accounting practices and the industry’s compliance standards. Review your bookkeeping efforts and ensure all financial data is correctly recorded so you’re prepared for financial reporting. Be sure to assess your current payroll practices to guarantee employees are correctly (and fairly) compensated. To maintain an accurate cash flow throughout the year, nail down your client billing and invoicing procedures and implement a practice-wide policy for payment collections. Next, head to the second chapter of PracticePanther’s Law Finance guide. We’ll discuss the best accounting practices for lawyers and the four basics you need to know for successful financial management.