Professional Services Accounting ARTICLE -
Determining how much capital your firm needs
Target Audience: Legal Professionals, Professional Service Firms, Law Firm Partners
Does your law firm have a sufficient amount of working capital to cover its immediate capital needs and its long-term goals? Capital needs include not only costs advanced and the average amount of a firm’s write-offs and write-downs, but also a cushion for the usual expenses and partner draws during billing and collection cycles. So how do you know how much is enough? Let’s look at factors that can help you determine how much capital your firm needs.
Where’s it coming from?
For a law firm, capital represents the investment needed to fund operations (working capital), along with that needed to purchase assets, pursue talent and go after mergers (long-term capital).
This funding can come in several forms. Contributed capital includes cash paid in by your partners when they become owners to help finance their share of firm operations, as well as any additional cash the firm may require partners to contribute. Added to this are any undistributed earnings.
Given the unevenness of collections, many firms need additional working and long-term capital. The most common types of bank debt are in the form of working capital lines of credit (which are used to fund operations and are usually secured by accounts receivable) and term loans (which are used to purchase assets and are usually secured by the assets being purchased).
How much is needed?
Every firm is different as to how much capital they need. If your firm has practice areas that require substantial out-of-pocket expenses on the behalf of clients, your capital requirements will be more substantial than those of a firm that covers those expenses through the use of retainers.
Develop a capital budget during your annual strategic planning and budgeting process. Your budget should include the capital needed to buy all substantial assets during the coming year as well as that necessary for growth either through acquisitions or internal generation from business development programs.
Combining this amount with the amount necessary to fund operations for the next fiscal year as determined by the budget, management can determine if the capital should come from partner contributions, bank debt, capital leases or undistributed earnings.
What will partners contribute?
The type of capital to be raised will depend on several factors, including your partners’ philosophy of borrowing against future collections and their appetite for holding on to a percentage of annual profits vs. obtaining funds from bank debt or funding asset purchases through the use of capital leases. While some firms are totally against taking on debt, others are fine with a significant amount of leverage.
If your firm determines that its partners should contribute some or all of the capital requirements, decide how much each partner should contribute. Some firms require equal contributions from each partner; others determine capital requirements in direct proportion to the amount of income earned in the previous year.
Depending on when the cash is needed, your firm may require its partners to contribute funds immediately or throughout the year. This is often done by withholding cash from each draw check.
An integral part of budgeting
As with any type of business, capital is essential to cover current and long-term expenses. By incorporating capital planning into your annual budgeting process, you can be assured that your firm will be prepared for the expected and unexpected.
Find out how our expertise in professional services accounting can add value to your business. Email us or call us at 1 (888) 875-9770.
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