THE GURU S GUIDE TO LAW FIRM PROFITABILITY

THE GURU S GUIDE TO LAW FIRM PROFITABILITY

Knowledge of industry trends can be a powerful decision support tool. Gaining access to industrywide data helps law firms measure their performance and profitability. With over 25 years of experience in the legal industry, Intelliteach has helped hundreds of firms understand the trends affecting their bottom line. We provide data that is otherwise difficult to obtain. For this edition of the Guru s Guide we assessed billing information provided by a large group of firms and clients through our Benchmarking and Business Intelligence reports. Every month we receive over a billion rows of transaction data which we process for law firms through our iris i3 Data Warehouse. Mining this data, we unearthed trends that all firms can use to guide them through the coming months. MARKET PERSPECTIVE Working closely with our clients, we saw that the soft demand for legal work in 2012 caused many firms to fall short of their budgets. For 2013 we see a continuation of the soft market and suspect that many more firms will fall short of their budgets. Many will fail to match their own 2012 revenue performance. We see that most firms have some plan to address the older A/R. However, for many it remains their primary cash flow problem. Much of the firms profits are tied up in aged A/R. Even though some law firms excel in this area, the majority are carrying more WIP and A/R than ever before. We are also seeing greater losses in Billing Realization and Collections Realization over the last two years compared to earlier years. The average ages of WIP and A/R continue to increase. Details of the calculations used for all statistics are shown in the Glossary at the end of the Guide. ABOUT THE AUTHORS Analysis and text written by: Michael J. Ferdman Sr. Vice President of Operations mferdman@intelliteach.com 314-625-9926 Data warehouse and calculations created by: Vergel J. Dytuco Sr. Vice President of Applications vdytuco@intelliteach.com 314-625-9947 Michael and Vergel were part of the team that created the iris i3 Analytics System. Using extensive knowledge of the legal industry, iris i3 offers a unique perspective into the inner workings of a law firm. With over 25 years of combined experience, Michael and Vergel have helped many firms achieve higher realization and greater profitability. 2

EXPENSES As expected, firms are still looking to control costs. A typical firm s expenses in this area break down as shown below. Estimate of Law Firm Back-office Expenditures Our data shows that law firms spend just over 11% of revenue on non-secretarial & non-occupancy staff functions. For a firm with revenue per lawyer of $500k, that is over $50k per lawyer on the back office. Finance, Administration & Office and Information Technology represent 69% of total spend. While necessary, cost cutting is not enough to offset market conditions according to most firms. To have a deeper impact on firm profitability, we have to look into the past in order to change the future. We have to examine what was worked, what was billed, and what was collected. If we can interpret the trends behind these actions, you can begin to realize more profits from the work your firm has performed. 3

BILLING STATISTICS BILLING RATE COMPARISON Year Avg. Worked Rate Avg. Billing Rate Avg. Collected Rate 2012 $383 $370 $334 2011 $374 $363 $327 2010 $360 $347 $315 2009 $351 $340 $315 Even in this tight economy, hourly rates have managed to gently rise. Notice that overall realization performance for Worked Rate vs. Collected Rate has fallen off slightly over the past three years. 2012 saw an average loss of $49 per hour from Worked Rate to Collected Rate. As a percentage, this loss does not represent much change over the last few years. However, losing $49 on every hour worked is a trend that needs to be reversed. To give perspective to this number, the firms used in our poll generated an average of over 340,000 worked-hours last year. INDUSTRY-BILLING REALIZATION 4 Billing realization is somewhat dependent on the type of law you practice. What is universal is that billing realization decreases over time. So for every dollar you can bill sooner rather than later, your firm will realize more of its value. Our real world experience demonstrates that many firms still do not regulate this function as well as they should. Some firms do not require daily tracking of time. This can allow for unintended losses in billing and the impact can be significant. If a firm with 50 timekeepers experiences even an hour per week loss across their billers due to lax policies, this could mean nearly $1 million in lost productivity. (50 timekeepers x 52 weeks x $380 average hourly rate, equals $988,000). The same degradation applies when billers don t release time to be invoiced as quickly as possible. For each $1,000,000 that is allowed to reach 120 days of age, only $554,000 will be invoiced. As you can see in the industry average graph above, there is nearly a 14% drop in realization on items billed at 60 days vs. at 30 days.

INDUSTRY DAYS OF UNBILLED TIME INDUSTRY AVERAGE BEST IN CLASS Calculate this for your own firm. Take the last 12 months worth of billing and divide that by 365. Take that number and divide it into the amount you have in WIP today. The number you come up with is the Days of Unbilled for your firm for the current month. INDUSTRY-DAYS OF UNBILLED TIME BY SIZE LARGE (200+) MEDIUM (100-200) SMALL (25-100) Small firms excel at billing quickly (days of unbilled), as well as getting high billing realization. The universal rule is that the longer it takes to convert worked time into an invoice, the less value you will receive. 5

PORTFOLIO PERFORMANCE RECOVERY PERFORMANCE AGAINST BILLED HOURS Year RECOVERY % OF TOTAL AR OPPORTUNITY AVG. DAYS OF AR AGAINST OPPORTUNITY YEARLY WRITE-OFF 2012 78.08% 76 3.22% 2011 78.30% 71 3.15% 2010 80.06% 71 3.05% 2009 81.45% 67 3.38% 2008 83.08% 62 2.63% Across the industry, firms continue to experience an increase in the time it takes to get payments from clients. The chart above shows a 5 year history of Recovery Rates and related performance indicators. The Recovery Rate shown above measures collections percentage from the Total Open A/R Pool for each year. Total Open A/R Pool for the year can be any age including prior years billings. Write-offs do affect this number by reducing Recovery, as those balances are never collected. As you can see, the industry recovers a decreasing amount of its open balances each year. As expected, this causes the average Days of A/R to increase. Write-offs are also increasing but not in a sufficient manner to account for the 5% decrease in Recovery since 2008. This means firms are carrying more A/R on their books than before. The write-off percentage above is calculated against the Total Open A/R in that year and includes balances older than the current year. How does your firm perform compared to your peers? Intelliteach will perform a baseline assessment at no charge. Contact Michael Ferdman at 314.625.9926 for details on sending your data. A write-off policy affects profits. Does your firm have a policy? 6

SIZE BREAKOUTS Year COLLECTION % OF TOTAL AR OPPORTUNITY SMALL (SIZE) 25-100 AVG. DAYS AR WRITE-OFFS 2012 78.82% 75 2.41% 2011 79.12% 69 2.36% 2010 81.05% 68 2.31% 2009 82.17% 64 2.87% 2008 83.59% 60 2.18% Year COLLECTION % OF TOTAL AR OPPORTUNITY MEDIUM (SIZE) 100-200 AVG. DAYS AR WRITE-OFFS 2012 79.54% 69 2.67% 2011 80.05% 67 2.68% 2010 79.70% 68 2.76% 2009 81.94% 66 2.40% 2008 83.13% 62 2.01% Year COLLECTION % OF TOTAL AR OPPORTUNITY LARGE (SIZE) 200 AVG. DAYS AR WRITE-OFFS 2012 71.26% 94 3.94% 2011 72.75% 88 3.47% 2010 76.20% 83 3.39% 2009 78.18% 83 3.28% 2008 81.32% 71 2.78% Large firms seem to have been hit the hardest, while the mid-sized firms performed slightly better than the other groups. 7

COLLECTION STATISTICS A/R AGING PERCENTAGE BY BUCKET (THIS IS YEAR-END DATA) SIZE 0-30 31-60 61-90 91-120 121-150 151-180 181+ LARGE 34.06% 13.26% 7.63% 6.24% 3.68% 2.71% 32.42% MEDIUM 33.98% 13.01% 8.85% 8.70% 4.14% 3.00% 28.32% SMALL 25.10% 12.32% 7.70% 5.41% 3.91% 3.81% 41.76% ALL 33.09% 13.12% 7.82% 6.52% 3.77% 2.87% 32.81% This is a look at the distribution of A/R by age buckets. As you can see, the industry carries a heavily back weighted inventory. In some practice groups a 6-month retainer or greater payment cycle is acceptable. For most others it should be considered intolerable. Remember that as A/R inventory ages, firms collect less than full value. Having 30-35% of the firms A/R aging past 180 days means that the firm will recover far less than 100% of these invoices. The industry averages just 44.1% collection rate when invoices pass the 180 day old mark. This type of graph is sometimes referred to as a Dumbell Distribution. All the value is on the front and back with little value in-between. 0-30 ALL OTHER BUCKETS 181+ Many firms report that this back weighting is somewhat affected by ebilling. Ebilling is approaching 25% of total billings, according to our research. Isolating ebilling from these calculations provides interesting results and will be covered in the next Guru Guide. INDUSTRY-COLLECTION REALIZATION 8

COLLECTION STATISTICS INDUSTRY-COLLECTION REALIZATION BY SIZE LARGE (200+) MEDIUM (100-200) SMALL (25-100) INDUSTRY-COLLECTION REALIZATION This is a look at how well firms collect over time. There are many ways firms calculate this, but the fact is, as invoices age you collect less of the value. An increase in collection realization of only 0.1% would yield large results in profits and cash-flow. Remember that all expenses are paid at this point so the increase in collections represents pure profit. More importantly, whatever your firm policy, if collections activities are moved up 30 days, say from 90 days to 60 days, your likelihood of collections succss increases dramatically (15%). Notice that large firms collect more over time but mid-sized firms collect a higher percentage of their aged A/R. What industry measurements would you like to see? Let us hear from you at MFerdman@intelliteach.com 9

AVERAGE COLLECTION SPEED IN DAYS FIRM SIZE 2010 2011 2012 0-100 100 102 103 101-200 78 80 75 201+ 80 80 80 ALL 83 83 82 AVERAGE BILL SPEED FIRM SIZE 2010 2011 2012 0-100 51 63 64 101-200 73 81 85 201+ 60 63 70 ALL 62 68 72 INDUSTRY BILL SPEED AND COLLECTIONS SPEED The above chart illustrates how long it takes the average firm to bill, and more importantly, to get paid. We look at how old the WIP was, on average, when it was billed, and the same for A/R age when it was paid. Notice that the smaller firms are the quickest to bill, but the slowest to get paid, highlighting the fact that it is not enough to concentrate on only one area. These are dollar weighted, so they highlight the true momentum for the firm, as opposed to individual invoice counts. Throughout the year we will have periodic updates to the data contained in this guide. Check our website at www.intelliteach.com for these updates. 10

INDUSTRY DAYS OF AR INDUSTRY DAYS OF AR BY SIZE The average firm has 73 days of A/R in inventory. This measure has increased by 3 days over the last 12 months. Ebilling seems to be a factor in why the industry is getting paid slower, but the main response to our surveys is that clients are holding onto cash and paying vendors slowly. Large firms seem to perform better in this area by collecting invoices faster. This could be due to the diversity of services delivered by larger firms (a varied client base), better internal controls, better Ebilling policies, or a combination of factors. 11

GLOSSARY BILLING RATE COMPARISON: A four (4) year history of the averaged dollar values for three types of rates: Worked Rate; Billing Rate; Collected Rate. We look at these rates for a calendar year. Averages are taken from all firms in the database. Worked Rate is calculated from the actual timecard table where time was entered for a specified calendar year. Billing Rate is calculated from the amounts that were actually invoiced in that same year. Collected Rate features a Mature Period method and is calculated from the actual collections from that year with a 2 month tail. To make sure we capture a significant amount of collections for a calendar year we look at receipts for invoices in a particular year, for two months past the end of a year. Using 2012 for example, we took the total collections from January 1, 2012 thru February 28, 2013 but only for invoices dated in 2012. We then divide those dollars by the hours billed in that year to create the average Collected Rate. Industry Billing Realization and Billing Realization By Size: The IRIS Realization method looks at a rolling 36 month period (so we always look at a full 36 months) with a 4 month lag. That means that 36 months of billable work are compared to 32 months of billing. The billable work over the most recent 4 months is ignored. We then calculate how old the billable work was at the time it got billed (if ever), so we can see how the value declines over time. We also group the results by firm size to allow peer-to-peer comparison. INDUSTRY - DAYS OF A/R: We look at total amount or billings for the trailing 12 months. We divide that by 365. This gives us 1 Day of A/R. We then divide that into the total current A/R amount to see how many Days of A/R are in inventory. We plot that over time to show seasonality. INDUSTRY - DAYS OF UNBILLED: We look at total worked amount for the trailing 12 months divided by 365. This gives us 1 Day of Unbilled. We then divide that into the total current Unbilled amount to see how many Days of Unbilled are in inventory. We plot that over time to show seasonality. Recovery Performance against Billed Hours: This is a five (5) year history of industry billing, collections, days of A/R, and write-off performance. Total Collections Opportunity (not shown) is calculated by adding the amount of A/R carried over from the previous year to the total amount billed in a calendar year. This becomes the total amount possible to collect in a calendar year, or Total Collections Opportunity Recovery % of Total A/R Opportunity. Average Days of A/R Against Opportunity, in this instance, is calculated by taking the Total Collections Opportunity for that year and dividing it by 365. We then take that 1 Day of A/R amount and divide it into the current open balance. We use our industry-wide data for this so it becomes the Average Days of A/R for the entire group of firms measured. Yearly Write-off is measured as a percentage derived by dividing the Fee billings for the year by the amount of write-offs for the year. For this instance, we include any write-off that happened in that calendar year regardless of the age of the AR/ written off. A/R Aging Percentage by Bucket: We break out the percentage of open A/R that exist in different age buckets. We show the industry numbers as well as a size breakout. This is calculated at year-end to give the best case scenario. Industry- Collections Realization and Collections Realization by Size: The IRIS Realization method looks at a rolling 36 month period (so we always look at a full 3 years) with a 4 month lag. The lag means that 36 months of collections are compared to 32 months of billing. The billings over the most recent 4 months are ignored. We then calculate how old the invoice was at the time it got paid (if ever), so we can see how the value declines over time. We also group the results by firm size to allow peer-to-peer comparison. Average Days to Bill and Average Days to Pay: We look at a rolling 12 months of WIP or A/R and average the ages of the items when they are invoiced or paid. We roll this up to an industry average or break it out by size. 12