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Episode 24
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Practice Management and Business Skills
Accounting for Lawyers
Law as stated: 13 October 2020
What is this?
This episode was published and is accurate as at this date.
In this episode, Nik Ahkin explains accounting concepts by reference to common issues experienced in legal practice such as managing pipeline, WIP and accounts receivable.
Practice Management and Business Skills| What area(s) of law does this episode consider? | This episode discusses the basics of accounting for lawyers. |
| Why is this topic relevant? | Accountants and lawyers often work together, yet few lawyers have a good understanding of the basics of accounting. This is important in commercial contexts as accounting is the so-called language of business and can help lawyers understand how to read the key documents that detail a business’ performance. Accounting and finance permeate other aspects of the law as well, such as examining a statement of assets and liabilities in family law – and at the end of the day, everyone earns an income that they need to pay tax on. Knowledge of basic accounting can help lawyers better understand their clients’ businesses and their own, and bring objectivity based on facts and figures when negotiating in commercial dealings. |
| What legislation is considered in this episode?
| No legislation mentioned in the episode, but generally accepted accounting principles (GAAP) are used as a tool to ensure consistency across the accounting industry. The global accounting standard is referred to as the International Financial Reporting Standards (IFRS) and are issued by the IFRS Foundation and the International Accounting Standards Board. Click here for a link to a PDF of the current 2020 IFRS Standards. The Australian Professional and Ethical Standards Board publishes accounting standards which are followed by Australian accountants. Click here to access the ATO’s practical compliance guidelines. |
| Key accounting terminology |
Both EBIT and EBITDA measure the performance of the business, ignoring how the business is financed.
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| What are the main points? |
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| What are the practical takeaways? |
What processes and products do you have in place at each link in the chain?
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| Show notes | Financial Management guide prepared by Nik Ahkin |
| David Turner:
1:00 | Hello and welcome to Hearsay, a podcast about Australian laws and lawyers for the Australian legal profession, my name is David Turner. As always, this podcast is proudly supported by Assured Legal Solutions, a boutique commercial law firm making complex simple. Just a quick note before we begin, the episode of Hearsay you’re about to listen to was recorded in the midst of the Corona virus crisis. As a result of social distancing measures we had to conduct this interview over remote technology such as Zoom or Google Meet, the audio quality might be a little different than what you were expecting. Still, we think it’s pretty good in the circumstances and we hope you enjoy the episode. Accountants and lawyers: we go together like peanut butter and jam, like peanut butter and chocolate, like peanut butter and, well, pretty much everything! We work closely with our professional cousins and both accountants and lawyers know the pain of having a deep interest in topics of conversation that might be a cure to narcolepsy for most people. But while we might often work together, few lawyers have a good understanding of the basics of the account’s craft and even a little understanding goes a long way to helping us work more effectively alongside accountants. Joining me today to discuss accounting for lawyers is Nik Ahkin from FBZ Financial. Nik thanks so much for joining me today on Hearsay. |
| Nik Ahkin: | Thanks David, great to be with you mate. |
| DT: | Now Nik, you often work with lawyers when you’re acting for your accounting practise clients, why do lawyers need to understand the basics of financial accounting? |
| NA: 2:00 | Accounting really is the language of business. So without a conceptual understanding of accounting and finance you will struggle to be a really good lawyer, I think. So understanding the numbers, understanding the history of the business, how it’s been performing, how it’s been tracking, what financial position it’s been in over the course of its life. It’s basically a bit of a thumbnail or a stamp to let you understand how the business has been running and how the owners have taken care of things over the last few years. |
| DT: | Yeah I mean hugely important to business lawyers, hugely important to lawyers working in commercial fields but also to lawyers in other areas. Family lawyers, for example who are working with asset distributions… |
| NA:
3:00
4:00 | Definitely. I mean so accounting touches all points of society really. TIP: Let’s think of a few other reasons why it might be useful to understand the language of accounting if you work in the law. Here’s one:
So this isn’t just a skill for the commercial lawyers – it pays to know this stuff in whatever discipline of law that you happen to practise. It’s also a skill that’s important for another reason – understanding the financial affairs of your own practice, which Nik will talk about shortly. So whether you run a business or not you still need to lodge a tax return at the end of the day. So whether you’re in a job or you run your own business, you’re earning income of some description and that income has obviously resulted in people buying assets, property, shares, and things like that, of the like. And these all need to go be documented somewhere. So lawyers need a pretty good understanding of accounting in general, but also I suppose the financial aspects of a person and a business. |
| DT: | And you raise a good point there that everyone’s earning an income hat you have to pay tax on. It’s important for lawyers to understand their own businesses and have the lens of accounting. |
| NA:
| In my experience lawyers are not strong on numbers and their finances. And it sort of really really hurts them. It’s one of the areas that they really need to educate themselves on and get a better understanding because it will benefit them professionally, how to talk to business owners, how to negotiate terms of contracts and things of the like, things that lawyers are very good at, technical terms and sort of negotiating with people and especially in business disputes and things of the like, it’s important when a lawyer can bring it back to the facts and the numbers, to bring back a bit of objectivity to the situation. |
| DT: 5:00 | Yeah absolutely and in terms of understanding your own business I think most lawyers when they’re considering the performance of their own business they’re thinking about: WIP, billed and received, and we’ll talk about how that apparently simple metric can be quite complicated from a recognition of revenue point of view a little later in the episode. But let’s start with the basics of financial accounting. What are the essential financial accounting documents? |
| NA:
6:00 | Well so there’s really three. And I’ll start with probably the most important I think is the balance sheet which is really just a snapshot of the assets, the liabilities and the equity accumulated in a business over time. That’s really your sort of north, south, east and west of a business. So that’s your starting point. Next you have your income statement which everybody knows is about revenue, your expenses and how much profit you are or not making in any given sort of period. So that’s more of a measure of performance over time and the financial performance of a business. And then we come to this sort of the cash flow statement which is all about money coming in and money going out of business. So that’s measuring everything from the operational cash flows, to how the business is financed, and also what assets it’s investing into. So and how the assets are being financed, whether that’s debt or equity or a combination of both. |
| DT:
| Now starting with the balance sheet, that’s probably a document that in one form or another most lawyers have had something to do with. Maybe they’ve had a statement of assets and liabilities in a family law matter, maybe it’s been a statement of assets and liabilities in an examination of a debtor, but the balance sheet is called that because it balances according to the accounting equation. Tell me a bit about that? |
| NA: | So basically the accounting equation is quite basic. So on sort of the left hand side or the top of the balance sheet, you have the assets and they must equal the equity and the liabilities. So if they don’t equal, you don’t have a balance sheet. |
| DT: | You’ve done something very wrong. You have an imbalance sheet. |
| NA: 7:00 | You have an imbalance sheet! So just the basics of that and understanding that ultimately the net assets is the equity component I suppose, and the difference that makes up the difference between the assets and liabilities. And so that’s really the basic equation that every lawyer should know. |
| DT:
| Now other than equity, the two important parts of the balance sheet are assets and liabilities. Those are terms that lawyers are familiar with using but they don’t necessarily have the same meaning in an accounting sense, do they? For example, when we’re talking about assets in an accounting sense, we’re not just talking about assets that are realisable property. |
| NA:
8:00
| Yeah and I think even accountants can learn a few things about what is an asset. And to me, an asset is something that produces income streams down the road. Whilst it might be a piece of plant equipment that sits in the business and has the capacity to produce products and things and goods and services that go out the door, it’s the other assets that probably are not accounted for in the balance sheet. things like systems, processes, your team capability and all those sorts of things, they are actually assets in a business, but they’re not necessarily documented inside a balance sheet. So there’s some things that lawyers and accountants can learn what is actually an asset inside a business. And it’s sort of, I think, it’s over a much broader definition over what I would say is the business model rather than just what’s in the actual balance sheet. TIP: This idea, that the balance sheet doesn’t capture some of the most important assets in a business, actually applies really well to law firms. The most valuable thing we have in a law firm is our people – their skills, their insights, their intelligence, knowledge and wisdom, their education and their personal connections to clients – but these can’t be measured in dollars and cents, so the only hint in our financial statements of this incredibly valuable asset is what it costs us in the form of salaries and employee entitlements. Now there’s a lesson in that – when we look at a balance sheet, we need to think about all the value that isn’t on it. |
| DT: 9:00 | That’s a great point because the balance sheet only captures assets that can be measured in monetary . That’s the monetary principle it’s called. So we’re not including perhaps the most valuable assets in a business which might be its people. |
| NA:
10:00 | Well it’s people, it’s its IP, its trademarks, it’s technology that it’s built overtime. For example in a tech business they have massive expenditure in terms of building out the technology for the business. But that’s all expensed, so it’s not actually included as an asset on the balance sheet when actually it is an asset because they have to build that technology before they can even get their first customer. So that particular expenditure that’s incurred is all written off. So really in terms of accounting principles, it’s kind of a mismatch I think. So it doesn’t follow the traditional sort of international accounting standards we’d be familiar with. It’s understanding that the expenditure you incur for some things fall into an asset bucket, and the expenses you incur for other things as more sort of operational. |
| DT:
| And I suppose that example of the software that’s been developed over many years, and perhaps doesn’t even appear on the balance sheet, is a good example of the balance sheet not necessarily showing the true value of an asset, or not showing even its realisable value, because usually assets are valued differently than that on balance sheet aren’t they? |
| NA:
11:00
| Yeah I mean most of the time it’s written on book value. So basically what you bought it for. There’d be a bit of depreciation applied and that’s based on, I suppose, the useful life of that asset whether that’s 2, 3, 4, 5 years whatever that might be, there’s a depreciable component of that asset that gets written down overtime. And so what ends up happening I suppose is the asset declines, so the business needs to invest in other assets to increase its asset base over time. So what you’ll find is that even though you’re looking at a balance sheet and you’ll have a number of assets sitting in there, and you’ll have to drill down in the details of those particular assets because normally it’s all summarised on the balance sheet they don’t have the actual particular listing of everything that’s in there. They’re often found in the notes of the financial statements if they are detailed in there at all. So it’s important to understand that the value of those assets may not have depreciated as much as written in the books. For example, you may have ordered a piece of plant equipment that you spend $100,000 acquiring. You may have depreciated over 5 years, $20,000 a year, and in 5 years that business goes bust but that plant equipment is still producing products and an output; it still has a value. And so that asset needs to be valued differently. |
| DT: 12:00 | I mean it’s particularly important at the moment when there’s different policy settings affecting the rate at which different assets are depreciated. I think software assets are depreciated over 3 years at the moment? Under ATO rules? |
| NA: | Yeah so I mean the ATO comes out with a specific guideline and that’s usually the ones that accountants follow. And that just sort of lines up with not only compiling the financials but also obviously doing tax returns. So it all sort of marries up nicely rather than creating your own complicated calculation and more rework for the accountant on the back end. |
| DT:
13:00
| TIP: As Nik says, there are various ATO rules about how certain types of assets can be depreciated, and as Nik says, it’s usually those rules, rather than the actual useful life of an asset, that determine how an asset is depreciated. One of those rules that many would be familiar with is the ‘instant asset write-off’, introduced as part of the COVID-19 stimulus measures, and that allows small businesses to claim the full cost of an asset purchase as a deduction right away, rather than depreciating it over time. Now we said before that one asset that appears on a balance sheet is receivables (money that you’re owed), and one liability that appears on a balance sheet is unearned revenue (money that you might have received but that you aren’t yet entitled to have). And that’s quite a relevant concept for a professional services business where as we said, we do measure performance based on WIP recorded, WIP billed and time received. Can you tell me a bit about the recognition of revenue and when you should be recognising something as a receivable or as revenue? |
| NA:
14:00
| Well receivable to me is when the work is done. So when you’ve gone through the machinations of completing the project or job or whatever you’ve been working on, and then a bill goes out for that work. But quite often what you’ll have in professional services firms is you’ll be doing a number of services or jobs along the way for a client, and you’ll be accumulating your time and services within those jobs. You may not necessarily be able to bill that because you haven’t delivered anything to the client. So it’s a work in progress. And I suppose the way you look at work in progress is really like, if you’re selling products it would be your inventory. So a good way to look at it is as if you’re holding too much stock you’re tying up your cash flow. But if you haven’t bought enough stock and you can’t sell enough, then you miss out on the revenue opportunities. So it becomes this little balancing act of not carrying too much WIP, but making sure you’re being efficient and you’re highly systemized and automated where you can be to get the jobs completed to a standard and making sure they come out the door quickly, so you can actually bill that revenue and collect on that revenue; can turn it into cash. |
| DT: 15:00 | I quite like that metaphor actually, I think that’s a good way of thinking about it. I think a lot of lawyers think about WIP as ‘well I’ve done work now so I’m entitled to the money,’ and billing it is kind of just a formality. But it is a bit like, recording the WIP is like manufacturing the product but you’re not selling the product until you’ve billed it and they’ve paid. |
| NA: | That’s right. |
| DT:
16:00
| TIP: Recognition of revenue can be a tricky issue for law firms. Back in June 2015, Slater & Gordon’s share price tumbled 43% after the announcement of an investigation by ASIC into anomalies in its UK arm’s financial statements. Now at the time, market analysts queried how work-in-progress was accounted for at the publicly listed firm – as some listeners would be aware, much of Slater & Gordon’s WIP balance comprised potential income on ‘no win, no fee’ matters, which could not yet be billed or recovered, and which was contingent on the outcome of those cases. Now Slater & Gordon were cleared of any wrongdoing, but you can see from the example how tricky recognition of revenue can be. All that WIP – at that time, about $1 billion worth – was definitely worth something, and you can see why you want it represented on the balance sheet. But what value do you give it, and what allowance do you make for the possibility – or on a big enough portfolio of cases, the mere certainty – that some of it won’t be able to be billed? Now we talked about how some assets don’t appear on the balance sheet. Some very valuable ones like capability and personnel, IP. Are there some liabilities that aren’t recorded on the balance sheet? |
| NA:
17:00 | I mean most liabilities are recorded if the accounting data is accurate. But what we find in a lot of businesses that they don’t have clean data to accurately record all the liabilities. So what ends up happening is you don’t understand what’s coming your way. And a good example of that is your tax liabilities and not understanding what obligations you have month to month, quarter to quarter, year to year. Those need to be documented somewhere so you have some understanding of what you owe and when you owe it. So that’s where your accounting data and your accounting information needs to be really streamlined so you can get that information and record those liabilities accurately. Cause if they’re not recorded accurately it can present some big financial troubles downstream. |
| DT:
| Yeah where you’re really overstating your net asset position which could cause, I mean just off the top of my head, if you’re subject to financial covenants under finance arrangements, that’s definitely one where not understanding your liability position and then having it suddenly change for the negative very dramatically could put you in hot water with a lender. Are there any other sort of issues that that could create? |
| NA: | I just think it creates a huge cashflow burden on a business especially when you’re travelling along in business and you think everything’s OK and then all of a sudden you find out that you’ve got a $100,000 tax bill to pay. Where do you actually find that money? Businesses are often left scrambling. That position becomes very stressful and hard to manage, so the importance of recording and being accurate on your liabilities is crucial. |
| DT: 18:00 | We’ve had another guest on the show talk about how one of those hidden liabilities is sometimes where employees have been treated as contractors or contractors have been treated as employees and when it turns out that that contractor is actually an employee and they’re actually owed 10 years of superannuation. |
| NA:
19:00 | That’s right. TIP: That other guest was Nicola Martin, employment practice group leader at McCabe Curwood. Try out that episode of Hearsay just after this one! Quite often what’s not recorded in the accounts is the leave liabilities things like annual leave, and long service leave and all those sorts of little surprise costs that sit within sort of your employee base that aren’t often recorded accurately or correctly. They may sit in the background in terms of your accounting system, so you probably can get those numbers if you need them, but I think it’s a good picture for those to be drawn into the financials so that the owners understand their obligations in terms of what are those employees that are actually costing them |
| DT:
| Important for M&A lawyers to understand certainly because when a client is looking at selling their business and they’re selling it based on, often it might be sold on a multiple of EBIT, which will talk about in a moment, but it might also be sold based on its net asset position. If that asset position turns out to be significantly diluted or even if it’s like you know cash-free debt-free basis and there’s employee liabilities to pay out, that can really affect the cash flow to the seller there. But also for lawyers who are selling their own practises, you know we’ve had a guest on the show recently talking about what lawyers can do to maximise the value of their own practise when they’re looking at succession. And having a lot of unrecorded employee entitlements on the balance sheet could really impact the value you can expect from that practise. |
| NA: 20:00 | Yeah definitely. So when you walk into a transaction there’s always surprises, right? It’s about understanding the financials inside a business. And probably being savvy enough to understand what should be there, rather than just taking the financials at face value. So once you understand all the components of what should be in the financials, you have a much better understanding of what to look for and what to watch out for on behalf of your client. |
| DT:
| Yeah, absolutely. Now let’s talk about the income statement and the purpose of that is to show a business’ revenues, expenses, and profit, but there’s a few different kinds of revenues and a few different kinds of expenses on the income statement. At the top you’ve got operating revenue and then usually after that you’ve got cost of goods sold, and then it proceeds on from there. Can you tell me why it’s split up the way it is and how you can use those different categories to understand a business? |
| NA:
21:00 | What most businesses tend to measure is that revenue figure. But what you really need to look at and focus on is your gross margin, or your gross profit. Cause unfortunately not every dollar of revenue is created equally. So you need to be aware that if I spend a dollar but if it costs me $0.50 to produce that dollar then I only get to keep $0.50. So understanding your gross margin is, it’s critical. And so that’s why it’s broken up in the P&L that way. Because to me the gross profit or the gross margin or what I’ve coined as your ‘real revenue’, it’s the revenue you get to keep and maintain. And so the goal really over time is to maximise the margin on that gross profit. So depending, and there’s different gross margins for different business models, but for a service firm, you’re looking at least sort of 60% gross margin minimum to remain viable and profitable. |
| DT: | And if you were seeing a gross margin below what you’d expect for that industry, what are some of the things that you’d be saying to that client? |
| NA: 22:00 | Well I’d be looking at their pricing, that’s a big key. Are you pricing your services accurately? Are you doing what most professional services out there try to do is they discount too often. And that’s really in an effort to bring more sales in the door. But what happens in the P&L is that that discount drops basically right to the bottom line and you become less profitable as a result. So in businesses your cost structures tend to stay the same. So every dollar discount is eroding profit over time and that may not hurt you in the immediate future, but if you keep doing it over an extended period of time, you’ll start to see less profitability. And as a result the business itself will produce less cash flow. So it will become a problem downstream. |
| DT: | I think sometimes people do that thinking ‘well we’ll build a customer base and then we’ll stop with the price promotion and charge profitable prices.’ But the problem is you might be acquiring customers who aren’t prepared to pay your price. |
| NA: 23:00 | Yeah exactly and this all comes down to the concept of working with and understanding your customer base intimately. So defining who your avatar is and who are the clients you want to work with, and really being specific on that. I think we shouldn’t be afraid to say no to people in professional services. If it doesn’t make sense and it doesn’t fit the bill with both the services that you offer and sort of the value you provide, you need to sort of walk away because long term it doesn’t work for your business. |
| DT: | Absolutely. Now we’ve talked about gross margin, or gross profit, another common metric that’s drawn from the income statement is EBIT or EBITDA. What’s that used to measure? |
| NA:
24:00 | Well that’s basically the overall performance of the business. So it’s earnings before interest in tax so that’s sort of I suppose you can take that to your operational performance. So you’ve earned all your revenue, you’ve paid for this sort of your cost of goods and you’ve got a gross margin sitting there, but then you’ve got all your operational costs, all your running costs, your overheads and things like that, rent, utilities, marketing and advertising and all those sorts of other costs. And then after that, all those expenses are incurred, that EBIT figure is a positive or negative. And that really tells you if the business is going well and is viable, or if it’s in a loss position it’s not doing so well. |
| DT: | Now why separate the cost of goods sold from those selling and administrative, or overhead costs? |
| NA:
25:00
26:00
27:00 | So I mean there’s two types of costs I suppose in a business. So you’ve got your variable which move up and down in accord to revenue and capacity. But then you’ve got your fixed costs which is more sort of where your operating costs sit in your P&L. They don’t tend to change too much. So your things like your electricity, your rent, fixed salary costs, they don’t tend to change from month to month so they become fixed. So what you really need to do is sort of analyse those fixed costs and then your volume is up the top and your pricing, and sort of help you understand that breakeven point for your business. TIP: The mix of fixed and variable costs that a business has is called its ‘operating leverage’. If a business has a higher proportion of fixed costs in its total costs, then it has high operating leverage; if it’s mostly variable costs, then it has low operating leverage. This is a useful concept to understand because it is a good measure of how the business will respond to changes in sales or, in the context of a law firm, utilisation. In a business with low operating leverage – remember, that means more variable costs, costs that go up and down with revenue – lower sales means lower costs, so the consequences of a quiet period in the business are not as great. By the same token, an increase in sales won’t result in a big profit margin either, since most of that extra profit is also carrying extra cost. However, in a business with high operating leverage – that’s more fixed costs than variable costs – there’s more risk, and more reward. If there’s a boom in sales, then a lot of that uptick is all profit, since the costs are the same as they were when the sales were lower, but if sales drop off, then you’ve still got to pay those high fixed costs – and hence the risk. A common example of a low operating leverage business is online retail – no bricks-and-mortar stores with expensive leases, no big manufacturing plants or expensive R&D – basically just the cost of inventory and the cost of shipping, both of which you don’t incur if you’re not selling anything. An example of a high operating leverage industry is the airline industry – two-thirds of their expenses tend to be fixed. Keeping planes in the air is expensive! So what about a law firm? Does a law firm have high or low operating leverage? Since the majority of costs in a law firm are salaries, I’d say they have high operating leverage. Salaries are the same whether you record lots of billable hours in a month or hardly any. And sure, while salaries are arguably variable – you can let people go if things get quiet, and you have to hire more people to do more work at some point – it’s not easy to do either of those things quickly. |
| DT: | And why exclude interest and tax? Why is that not something that you look at when you’re looking at the operating performance of the business? |
| NA:
| Yeah so I mean the thing about interest is you could have a business side by side right and it could have no interest because it’s funded by equity. And then you could have another business which is completely funded by debt and there’s an interest expense incurred. So the difference between the two is just how that business is actually financed. So it’s not an indication of financial performance it’s just how the business or how the company is financed. |
| DT: | Yeah absolutely I mean the way I think about it is that it’s a financing agnostic measure of the business’ . That if you’re funding it with a loan that’s paying 35% interest, then no business is going to be profitable financed that way. |
| NA: 28:00
| Yeah so your cost of debt is too high there. So that’s when again coming back to the balance sheet, understanding all your liabilities and then mapping that to your cost of funds. Because at the end of the day understanding your capital structure is probably the most critical in judging performance and viability of a business. Because your capital structure is what debt and equity is used to fund the assets and operations of the business. TIP: An example of a business that was profitable but went bankrupt for just this reason is American Apparel, the American clothing manufacturer. It was profitable based on EBIT, but it was funded with expensive debt from a number of different lenders. In 2014, those loans went into default when the CEO was ousted by the company’s board – and in 2015, American Apparel filed for bankruptcy. So that’s a really critical piece that lawyers need to understand. |
| DT: 29:00 | And an important part of that, I suppose particularly for M&A lawyers or lawyers who advise on areas where tax is relevant, is the tax shield that interest expense can create. Can you tell me a little bit about that concept of the tax shield? |
| NA: | I mean the tax shield is just a fancy way of getting a tax deduction on taxable income. So it’s basically based on whatever your rate or percentage of tax is, you get as a deduction benefit. So if you’re claiming $10,000 of interest and your tax rate is 30% and then you’re getting a 30% tax shield. |
| DT: | So there’s a kind of an ideal mix of debt and equity for a lot of businesses. |
| NA:
30:00 | Yeah so you need to have, and this just comes back to my point about the capital structures, is coming up with the optimal sort of mix, capital mix, inside the balance sheet. Because really you don’t, I mean if you take on too much debt, your cost of funding goes up too high and that hurts your cash flows and ability to grow. Whereas if you take on too much equity, you have the opposite effect when the business becomes super successful downstream you’re paying an awful lot out in terms of profits and dividends. So you need to sort of get the balance right between debt and equity. So good businesses should have a combination of both, and uh @30:17 sort of reduce that cost of capital inside the balance sheet. |
| DT:
| Nik in your experience what are the most common accounting errors that lawyers make in the books for their own businesses or the common mistakes that any professional service provider makes in preparing the books of their own businesses? |
| NA:
31:00
32:00
33:00
| I think probably mapping your operational systems and data into the finances is a big mistake. Whereas your finance looks ahead at the forecasting component, what’s coming up next month, the next quarter, those types of things. So what you really want to do is be mapping your operational systems in terms of your CRM, your lead flows, what’s coming into the business, how much you‘re converting, what products and services they are actually buying from the business. So quantifying that customer value component that comes into the business each time. And then looking from a delivery point of view, looking at your workflow plan and your workflow systems and what jobs you’re going to complete, and what you’re going to get done, what you’re going to be able to bill out at the end of the day, so you really need to map those two sort of architects together in order to build a true financial picture of how the business is performing. And I think the best way to do it that I’ve found is a technique of creating a sort of a business value chain. So that’s basically for when someone doesn’t know anything about what you do and the problems and the people you help, to them coming into the business, using your services and then becoming a raving fan. So it’s almost like a value process that they go through and that can sort of be broken down into three major buckets. So you got your marketing where you’re sort of speaking to your audience and trying to attract the customers into your business. Your sales which is how much you’re converting at the day and what you’re selling them. And then you’ve got the fulfilment side, which is your operations and delivery of the product or service. So you need to map all that together, and then once you do that you start to see the bottlenecks that are happening inside your business. So, what we often find is especially in professional services firms most people think that they need more leads, or they need better marketing fancier stuff at the front end when in actual fact, if you fix the fulfilment side and create a great customer experience and you’re delivering quality jobs on time, what you’ll find is you’ll just get natural referrals and natural growth from that process alone. So really coming back to that concept of the value chain, really super important for businesses to understand and unpack because people talk and there’s a lot of advisors out there that talk about KPIs and what you should measure and monitor and they throw out examples of monthly recurring revenue growth and gross profit margins and sort of what systems you should have in place and all that sort of stuff, but I think you need to bring it back to the top line. And really start to unpack and measure that value chain that you have. And that sits inside every single business on the planet. |
| DT: 34:00 | I think that’s great advice and a great way to use some of these tools that we’ve been talking about in a practical , and in a future focused way. I do think a lot of lawyers think of growth in their business as a function of generating more leads. That once we’ve got the work, we’ll kind of get it done somehow, but the only way we can earn more money is to attract more new clients. |
| NA:
35:00 | Well there’s multiple ways to grow. So getting more leads in the business is one, but it’s often a very small component. So another way to grow is what sort of other products or services you can offer your existing customers. Sort of increasing your prices and average transaction value inside the customer base. And just making sure you’re just building that stellar sort of customer experience so you’re getting natural referrals. So, and the other way to ensure that growth is consistent and maintained is retention. So just getting the lead is important yes, but making sure you’re retaining the customer and giving them the best experience possible, that is going to allow you to grow exponentially. |
| DT: | I think it’s up to 8 times cheaper to keep a customer than to acquire one. |
| NA: | Yes absolutely, so in terms of a cost point of view, it’s obviously much much more cost effective to retain and sell within the customer base than is to go out to the market and start spending money on Facebook, and Google, and all the other platforms that are really taking the profits. |
| DT: | And speaking of that dramatic difference between the cost of acquiring a customer and the cost of retaining one it’s often the case, isn’t it Nik, that businesses don’t really accurately record or even monitor what those customer acquisition costs are? |
| NA:
36:00
37:00 | Yeah and they’re a difficult one to measure data. So most professional services firms, they don’t really have sales teams. So it’s not like you assign a cost to a salesperson inside the business. They may employ sort of a marketing agency or someone inside the firm that sort of handles the marketing, you can sort of assign those costs, but customer acquisition cost is a very hard one to measure. Because you’ve usually got a partner bringing in all the jobs, all the work. He’s what they call the ‘rainmaker.’ Do you put his salary into the mix on the time and effort and energy he spends in terms of acquiring the new customers he brings into the firm? That’s often not captured at all anywhere. The lunches, the phone calls, the texting and everything else that they do. The other thing to be conscious of is your marketing costs because sometimes they can get out of hand. Especially with the big push for social media and sort of getting your business out there and getting your name out there. There is a massive cost associated with that even if you’re not exactly running paid advertising, even if you’re building content marketing to produce videos and write blogs and do all those content pieces. So it’s really hard to capture all the costs that go into actually getting a customer. But you’ll find if you’re investing heavily in your marketing, and that’s a big expense in your business, that tells me that you don’t have a very good business because you should be reducing that marketing costs as much as possible because what really should be happening is you should be getting that organic growth from that fulfilment side and growing your transaction value in your other sort of revenue levers and sales levers you can pull rather than relying too much on your marketing to bring leads into the business because those costs can get out of hand, they can sort of weight you down over time. |
| DT:
38:00 | I think on that topic of not measuring customer acquisition cost well, I think one of the reasons why lawyers don’t do that so well is that often it’s because we don’t have that sales team. Often it’s kind of an opportunity cost. It’s the fee-earner time spent on customer acquisition that isn’t being recorded to a matter. And so the tangible amount of time isn’t recorded in financial terms. |
| NA:
| And you’re right it’s an opportunity cost right, it’s you’re going in chasing an opportunity rather than maybe focusing on what’s in front of you and what you can do immediately to generate income and revenue for the business. But look it’s different for every business, I mean some rainmakers do incredibly well and they bring big matters into the firm, everyone’s got plenty to get on with and work on. Whilst sometimes some partners tend to lunch too much… |
| DT: | That’s right yeah. |
| NA: | And often, and we’ve all seen partner splits and things, we’ve been around professional services firms for a long time. We know if you’re not bringing in the dollars, well… |
| DT: | That’s right. |
| NA: | Then you’re not long for this firm. |
| DT: | There’s not too many long lunches left! |
| NA: | That’s right! |
| DT: 39:00 | Now the last financial accounting document that we’re going to talk about today is the cash flow statement. This is one that’s often not part of the consolidated financial statements and so it’s one that lawyers might not have seen as often; the consolidated financial statements often being a document that comes up in litigation for transactions. Why do you need a cash flow statement when you’ve got an income statement that’s showing whether or not their business is profitable on a variable cost basis, or an EBIT basis? |
| NA:
40:00 | The problem with financials is it’s a measure of the past and very much a lagging indicator. Cash flow statements are not often put into sets of financial statements because they’re basically just prepared for tax purposes. So all the accountant is trying to do is quantify what the tax is. Whereas if you look at what a CFO would do is that they would be obsessed with the cash flow statement. So they would want to forecast the revenue coming into the business, the operational expenses, what cash is coming in, what capital they have available in the business, what cash is coming in and out, so your sort of operational cash flows they’re very obsessed with. And also how much money is tied up inside working capital is another big one. So that’s your accounts receivable, your accounts payable and in the instance of a professional services firm, it would be your sort of work in progress which would be a quasi-stock I suppose. So that would sit in as your working capital. And the idea, I suppose the goal, of any good business is to reduce that working capital as much as possible and sort of turn the revenue into cash as quickly as you can. |
| DT: | And when we’re talking about a cash flow statement, unlike some of the other documents we’ve been talking about today, we’re not talking about book values and non-cash expenses, we’re talking about realisable value… |
| NA: | Yeah well you can’t hide cash. So you know cash is something…I can’t ring up my bank and change my bank statements. |
| DT: | Would be nice. |
| NA: 41:00
| Would be nice if you could, if they’d put in a few extra deposits on the right hand column, but I can’t do that. And whereas an accountant can easily go in and manipulate a P&L. So they can bring expenses forward, they can pull expenses back, they can bring revenue into the business, they can do all sorts of things with receivables and they can play all sorts of tricks to sort of inflate the performance or reduce the performance of a business. Whereas the cash flow you can’t hide. It specifically measures cash coming in and out of a business which is basically tied into the bank statements. So you just can’t falsify that stuff. |
| DT: | Yeah. But as you said it’s often a prospective document as well as a historical one, often it’s an estimate of what’s going to happen in the future. What do you look out for when you’re looking at an estimate of cash flow, or a cash flow forecast, to determine whether or not it seems to be accurate to you? |
| NA:
42:00
43:00 | I mean the problem with forecasting is it’s never accurate. But that’s OK, that’s not the point of it. The point of a forecast really is to think through the business in a deeper sense so as to understand what revenues and jobs you’ve got on the go, and what you’re going to be billing and banking in any given month. And then sort of looking ahead at all these sorts of what costs you’ve got coming up, and then also capturing the liabilities you’ve got to pay. So you’ve got to set aside. So having that forecast process and sort of understanding your cash buckets is really important in any business, it doesn’t matter what you’re running. So the best way to do it is, I think, is to set up separate bank accounts. So you’ve one bank account for your operating expenses, you’ve got one bank account which is swept across some money for your taxes and your sort of employment obligations such as your super and things like that. And then you’ve got another bank account for profit and growth. So that’s things that you may want to invest down the line such as maybe a new technology, a new system, a new subscription, some marketing sort of more growth focus. So when you split those sorts of amounts up in the business, and we’ll provide more details in the show notes on this so you can read through it, you can start to sort basically know exactly how much cash you’ve got in each bucket and then what you need to allocate out. So there’s a bit of a technique to it. So it’s quite technical but very effective. |
| DT: | Yeah and I’m looking forward to having a look at that tool as well, as I’m sure our listeners are. I think the old adage is ‘what isn’t measured can’t be managed’ and I like that idea that look, even if the forecast is not correct and you can almost guarantee that it won’t be, it’s really more about the process of thinking, as you said, thinking more deeply about the business and its immediate future. |
| NA:
44:00 | That’s right so yeah it’s really understanding how you are going to optimise revenue, how you’re going to basically slim down or make your costs as lean as possible, by making your business model effective. Because if your business model is not profitable it doesn’t work. So measuring these things and you need to measure yourself against some sort of goal or performance down the track. So if you set lower targets, you’re probably going to hit those low targets. Whereas you set higher targets, you might never get there. So it’s a really good process to go through and very worthwhile. |
| DT:
| And in terms of growth and the growth that you’re measuring or charting with this tool, I mean one cash outflow that you won’t see on an income statement but that you’ll definitely see on the cash flow forecast is cash outflows for investment or for capital expense. Can you tell me a bit about recording those on a cash flow statement, and why it’s important to understand? |
| NA:
45:00
| So there’s three buckets that sit on the cash flow statement. So you’ve got your operating cash flows, which is your day to day trading and running expenses. Then you’ve got your financing, which is any equity or debt introduced into the business at any given time and that’s to fund assets or operations of the business. And then you’ve got your investing component which is sort of your capex if you like, which is sort of what assets you’re going to be buying and purchasing down the track. That’s really important to understand. But I suppose the best formula to learn in business is what I call free cash flows. Yeah so the best way to think about how a business is really performing and tracking is understanding the free cash flow formula. So that’s taking your sort of EBITDA or your profit and then subtracting that from any capital expenditure that you’ve made in the period, and also subtracting your networking capital. So that will give you the true free cash flows back to the business. And if that’s positive and growing, that’s what actually creates value inside of a business. |
| DT: | That’s kind of your holistic outlook on the business? |
| NA: | Yeah it is, it’s your holistic outlook that you have to have to understand how you’re tracking over time. |
| DT: 46:00 | And that kind of brings together the three documents we were talking about today, of all the insights of those different measures of financial accounting. |
| NA:
| So it’s one of those things where it’s a catch-all formula. So it brings together the income statement, the cash flow statement and the balance sheet all in one, because obviously the idea of business is to generate as much free cash flows as possible because then you have more money to either grow or you have more money to pay yourself, so it’s a very important metric to measure. |
| DT:
47:00 | And we’ll be including an infographic that describes the free cash flow formula in the show notes that’s available on the Hearsay website. Now what we’ve been talking about today has been financial accounting for the most part and a term related to financial accounting that a lot of lawyers will have seen, litigators will have seen it in expert reports, deals lawyers will have seen it in lots of transaction documents I think I threw it in somewhere earlier this week, is GAP, or generally accepted accounting principles. We’re often saying that when we’re describing how an asset is going to be valued, or how a statement of profit is going to be prepared for an earnout clause or something like that, but what are generally accepted accounting principles? |
| NA:
48:00 | I mean they’re just a guideline for the profession for how things are documented and viewed inside an income statement, a balance sheet. There’s international accounting standards and then basically that dovetails into I suppose your national standards, so it gets broken down. But generally, because we live in such a global society, the international standards are pretty much followed. Especially in sort of Australia, US and Europe in those sorts of regions it’s all pretty consistent across the board. TIP: In Australia, the Australian Professional and Ethical Standards Board publishes standards for professional accountants, which are consistent with these international standards. For example, the financial statements Nik and I have been talking about today are prepared by Australian accountants consistent with APES315. So whether you’re doing transactions across borders, you’ve got that one common language that you can talk to, each accountant can talk to each other. As I said at the start of the show, accounting is the language of business. That’s just the procedures and the policies documented just to make sure everyone’s on the same page. |
| DT: | And so using those generally accepted accounting principles gives you a kind of consistent set of rules for how those accounting aspects of a contract will be… |
| NA: | Because then you’d just be getting professional accountants, I mean they do it, they take liberties with it anyway, but if we take any more liberties it’ll become more confusing for everybody. |
| DT: 49:00 | The topic I wanted to finish on today was management accounting. Now we’ve talked a bit about financial accounting today, how does management accounting differ to financial accounting and what’s it used for? |
| NA:
| Yeah so the way I look at management accounting is really reporting on business performance. So that’s your margins, your cash flow and sort of how you’re tracking from month to month. So it’s really looking at the short term and short term bursts of how you’ve been performing. And then doing the sort of your unit economics and understanding what it costs to produce a product or a service and understanding per product if you’re profitable or not. Some businesses have thousands of products, so you need to apply those unit economics to each of those products. So I suppose management accounting is supposed to the granular look at a business, whereas financial accounting is more just recording what’s there in the transactions that have been in the past. |
| DT: | And I guess a key difference is, again going back to generally accepted accounting principles, is that management accounting is a little more freeform that it could be a little bit more specific to the enterprise that it’s being used in. |
| NA: 50:00
| Yeah and I suppose it’s one of those things where you know, who’s doing the management accounting inside the business? And quite often there’ll be no one doing it at all. So you’ll have your external accountant, and he’s doing his thing and they are more focused on tax and making sure you’re sort of meeting your obligations compliance-wise, but is there anyone inside the business actually measuring the performance from month to month? And you’ll find that as you grow your business you need to get more critical on how you’re measuring performance each step of the way, because, you know, you don’t want any surprises as you grow. So being on top of the numbers and being on top of your management accounts, lets you track trends and understand how the business is performing over a certain period of time. |
| DT:
51:00 | We’ve talked a bit about how lawyers measure their performance, and although management accounting can be very specific to individual businesses and there’s no kind of one way to do it, what would your tip be for a law firm or a law practise to use management accounting to understand the performance of their business better? How could they do that? |
| NA:
52:00
53:00 | I think it starts with itemising out all the services that your law firm provides, and then usually lawyers will charge an hourly rate and you need to dissect what services your customers are buying the most and then how efficiently you’re producing that service. A good example might be property transfer documents. And that’s a highly administrative thing, but if you automate that and streamline the process inside the business, you can make that profitable over time if you have the right systems in play, even though it’s a relatively pretty low margin service. Whereas if you’ve got your litigation, which is obviously very high margin and very lucrative, but the problem with litigation is the cash flow components are not that generous. Quite often lawyers are sitting on a huge amount of unpaid work and they don’t actually see the fruits of all that work until a settlement or commercial deal is reached. And that sometimes can be won sometimes even two years even more, down the track. TIP: Do you look at the breakdown of your work this way? I think that sometimes lawyers, and I include myself in this, think of all work as equal – if it’s coming in the door, then it’s work that you want. But what Nik is saying is that this isn’t necessarily right – you’ve only got so much time in the day, and you should be chasing a mix of work that provides the right balance of profit margin and cash flow. So it’s really understanding the services you’re providing and breaking this down and we’ll put a sheet together for you in the show notes to help you dissect your service lines and understand which ones are producing the most profit for your business. |
| DT:
| Today we’ve talked about how lawyers can use the basics of financial to better understand their clients’ businesses and improve the services they are providing their clients and also to understand how their own businesses work and to manage their own practises better. If there’s one tip that you’d want to leave our listeners with today, whether it’s about advising clients on issues that are connected to the basics of accounting or whether it’s understanding their own businesses, what would that one tip be? |
| NA:
54:00 | My tip is generally in business is really know your numbers. So that’s having an understanding of all these accounting terms and concepts and what sits on an income statement, balance sheet and cash flow statement, but really understanding what’s important for you to measure and it’s different for every business model. So if you’re selling services it’s different selling products. So the numbers and the metrics that you measure in the business is going to be critical, but as I said before I think every business should understand their value chain because once you understand the value chain, you understand what to actually measure to improve performance because you get to see the bottlenecks in your marketing, your sales and your fulfilment. And as I said you always start with fulfilment because that’s where often the hidden gold is in most businesses that we come across, including services firms, law firms. |
| DT: | Yeah that’s a great tip not only for our listeners but for their clients as well. Nik thanks so much for joining me today on Hearsay. |
| NA: | No worries David, thanks mate. |
| DT:
55:00
56:00 | You’ve been listening to Hearsay The Legal Podcast. I’d like to thank our guest Nik Ahkin from FBZ Financial for coming on the show. Now if you liked this episode about finance and accounting, why not try my interview with Dr George Beaton about microeconomics for lawyers. Or if you want something different, refresh yourself on the basics of the Personal Properties Securities Act 2009 (Cth) with Nicolas Mirzai and Jason Porter. Now if you’re an Australian legal practitioner, you can claim one continuing professional development point for listening to this episode. Whether an activity entitles you to claim a CPD unit is self-assessed, but we suggest this episode constitutes an activity in the practice management and business skills field. If you’ve claimed five or more CPD points from audio content already this CPD year, you might have to access our multimedia content to claim further points from listening to Hearsay. Visit htlp.com.au for more information on claiming and tracking your points on our platform. The Hearsay team is Tim Edmeades our audio engineer, Kirti Kumar our chief researcher and content writer, Araceli Robledo our business development manager, and me David Turner. Nicola Cosgrove is our executive producer and she keeps all the wheels turning. Hearsay The Legal Podcast is proudly supported by Assured Legal Solutions, making complex simple. You can find all of our episodes as well as summary papers, transcripts, quizzes and more at htlp.com.au. That’s HTLP for Hearsay The Legal Podcast.com.au. Thanks for listening and I’ll see you again next time. |
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