Manus Quinn examines the warning signs that, if identified early, can greatly improve the recovery prospects of firms in financial difficulty.

An inevitable consequence of the recent economic turmoil is that some professional practices, large and small, are suffering from falling profits and liquidity issues. In extreme cases, this has led to the failure of some firms. For every high-profile failure, such as the administration of Cobbetts LLP earlier this year, there are numerous, less well-reported failures of smaller firms. There has also been a marked increase in professional practices and their lenders seeking restructuring and insolvency advice – a trend that is unlikely to reverse in the near future.

As a further indication of this problem, in our latest annual survey of the legal sector, the greatest concerns to firms were the fragility of the UK economy, pressure on fees and maintaining profitability. Cuts in legal aid, the Jackson reforms and increased competition from 'Tesco law' are also unwelcome contributory factors to a general lack of confidence within the sector.

Common warning signs

The first step to stability and recovery is to identify (and accept) there is a problem. Below are some of the more common warning signs that a firm may be heading for trouble.

  • Lack of clarity and agreement on the firm's strategic direction – The goals of senior/equity partners are often at odds with those of junior/salaried partners, leading to incongruent behaviour.
  • Higher than expected rates of voluntary departure of partners and other key fee-earners – Dissatisfaction with the direction of the practice or perceived unfairness in the reward structure may well lead to the exit of better performing fee earners. Together with a failure to deal with weaker performing staff, this can result in dissatisfied clients and subsequently falling profits and lower billing recovery rates.
  • Inadequate management information systems – Firms should prepare management accounts to assess their trading performance and current financial position (especially lock-up). They should produce an annual budget, apply key performance indicators (financial and non-financial) and short-term cash flow forecasts. These tools are essential when it comes to making the appropriate decisions to maximise profits and control cash.
  • Level of drawings not realigned with lower profits – When profits start falling firms often fail to realign their outgoings, resulting in a depletion of cash reserves or increased reliance on overdraft facilities. A further consequence of this is an imbalance in levels of bank debt compared to partners' capital.
  • One or more new initiatives requiring capital investment – This can include expansion into new territories or service lines – usually slow burners in terms of revenue and profit generation, while being a significant cash drain in the early stages.
  • Passive billing and collection procedures – While lock-up is a contributory factor in many cash- stricken firms, accelerated billing and collection processes can have a dramatically beneficial effect on liquidity in a relatively short period of time, reducing the level of funding required from other sources (especially the bank and the partners themselves).
  • Lack of professional advice and support – Denial and/ or unwillingness to seek professional advice is common among professional practices. While a natural reaction may be to try to resolve issues within the sanctum of the firm, the implications of wrongful trading, particularly when coupled with unlimited liability (if a general partnership), should be a sufficient wake-up call to being more proactive in getting external professional advice.

Identifying and dealing with issues quickly and conveying the subsequent strategy (and progress towards delivering it) to key stakeholders, including the bank and your own staff, will greatly improve the chances of recovery and survival.

We have taken great care to ensure the accuracy of this newsletter. However, the newsletter is written in general terms and you are strongly recommended to seek specific advice before taking any action based on the information it contains. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. © Smith & Williamson Holdings Limited 2013. code 13/1077 exp: 31/03/2014