Elevating Your Law Firm’s Financial Performance: The Power of Budgeting and Forecasting

“The best way to predict the future is to create it.”

– Abraham Lincoln

Budgeting + Forecasting = A Winning Formula for Law Firm Success

Forecasting a budget allows a law firm to anticipate future expenses and revenues, and to make informed decisions about how to allocate resources in the present. It allows the firm to plan for potential changes in the business environment, act quickly in the face of such changes, and take steps to mitigate risks and capitalize on opportunities. A law firm can identify areas where it may be overspending and make adjustments to reduce costs. And it can also identify areas where it may be underinvesting and make adjustments to increase revenue.

In other words, by creating a budget and forecast, you can set financial goals, track progress, and make informed decisions about how to allocate resources. But it is not just about numbers, it is also about understanding your firm’s performance and identifying areas of over or under-performance.

First, however, let’s talk about the numbers. Even when working with outside accountants, it is important to have an understanding of the fundamentals behind budgeting. The fundamentals of budgeting involve creating a plan for income and expenses, and one of the key metrics to keep in mind is the gross profit margin, which measures the amount by which revenue from sales exceeds the cost of goods sold. From an accounting standpoint, the Gross Profit Margin formula can be used to determine the profitability of a law firm by calculating the percentage of revenue that is left over after deducting all the costs associated with delivering the legal services. This formula can be written out broadly as follows:

Gross Profit Margin = 
    (Total Fees Earned - (Direct Costs (e.g., salaries, rent, supplies) 
                            + Indirect Costs (e.g., marketing, IT support) 
                            + Depreciation 
                            + Amortization 
                            + Interest Expenses)) 
    / Total Fees Earned

Using this formula, we can set financial goals and track progress by comparing the budgeted and forecasted gross profit margin to the actual gross profit margin. Additionally, the formula allows law firms to identify areas of over or under performance and make informed decisions about allocating resources. These metrics are key when it comes to cost savings.

When applying the formula that you will need to have accurate, broken-down data, and you need to be consistent in your application of the accounting principles:

• Accurate data collection: Ensure that you have accurate data for Total Fees Earned, Direct Costs, Indirect Costs, Depreciation, Amortization, and Interest Expenses.
• Breakdown of costs: Breakdown the costs into specific categories, e.g. employee salaries, office rent, office supplies, marketing, professional development, IT support, and Depreciation and Amortization.
• Be consistent: Use consistent accounting method throughout the calculation.

Keeping that in mind, we now turn back to the formula.

By way of overview, applying the formula starts with understanding the key financial metrics that are vital to your firm. For most firms, this includes the typical categories: revenue, expenses, profits, and cash flow. By tracking and analyzing each of these metrics over time, you can gain a better understanding of your financial performance and make more informed decisions about how to allocate resources. This may feel like a full time job, however, so it is important to work with experts who can assist in tracking the financial analytics over time.

That being said, you separately need to take into consideration other factors that can affect your financial performance, such as the type of cases you handle and the size of your firm, seasonality of work, etc. For example, if your firm specializes in personal injury cases, you’ll need to budget and forecast differently than a firm that focuses on corporate law.

Once you and your outside accountants have a clear understanding of your financial metrics and other factors, you can start to set realistic financial goals for your firm. This is where budgeting comes in. By setting revenue targets and estimating expenses, you can create a budget that will help you achieve your financial goals. And with the help of accounting software, you can track your progress over time and make adjustments as needed.

Now let’s look at some of the steps you should be taking when preparing a forecast and budget for your law firm.

Forecasting is the next step. Here you will analyze past financial performance and consider future trends to create a projection of what you can expect in the future. This will help you to identify potential challenges and opportunities, and make strategic decisions accordingly. Forecasting tools and software can be helpful in this process, making it easier to create a detailed and accurate forecast.

As your firm progresses through the year, it is important to monitor and adjust your budget and forecast as needed. Budget variances can help you identify areas of over or under-performance, and allow you to make adjustments accordingly. This may include reallocating resources, cutting expenses, or finding new revenue streams.

Creating The Budget For Your Law Firm

Creating a budget for your law firm starts by setting revenue targets. This is where you project how much money you expect to bring in through different streams of revenue, such as client fees, settlements, and investments. It is important to be realistic, consider the type of cases your firm handle, and the size of your firm.

Once you have an idea of your expected revenue, you can then estimate your expenses. This includes both fixed expenses, such as rent and salaries, and variable expenses, such as marketing and travel. By comparing your projected revenue and expenses, you’ll be able to see if you have a surplus or deficit, and make adjustments accordingly.

Remember: creating a budget is not enough, you must also track your progress and make adjustments as needed. This is where external accountants come in. With the help of external accountants, you can create a budget and track progress over time. You can provide your projected revenue and expenses to your accountants and then regularly compare your actual performance to your budget. Accountants can also help you to identify variances and make adjustments as needed. Additionally, they can also help you to create reports and charts that can be shared with other members of the firm, making it easier to communicate budget and financial information.

By creating a budget, tracking your progress and making adjustments as needed, you will be able to ensure that your law firm’s finances are on track and that you are making the most of your resources. It is also important to note that budgeting is not a one-time process, but an ongoing effort that requires regular monitoring and updating. By staying on top of your budget, you will be able to make informed decisions and ensure the long-term financial success of your law firm.

Creating The Forecast For Your Law Firm

Creating a forecast for your law firm can seem like trying to predict the weather, but with a lot more paperwork. But it is not as hard as you think, especially if you have help. It all starts with analyzing your past financial performance. You must carefully scrutinize your financial metrics such as revenue, expenses, and profits over a period of time. Through this exercise, you will be able to identify trends and patterns that can give you an idea of what to expect in the future. Think of it like reading tea leaves, but with numbers instead of leaves. Sometimes, the type of Law Practice Management Software software you use can make a difference.

Once you have a clear understanding of your past performance, it is time to consider future trends. This is where things get a bit more tricky. You’ll need to consider external factors such as the economy, changes in laws and regulations, and shifts in the market. Again, this is like trying to predict the future by reading your horoscope, but with less mysticism and more spreadsheets. Here are some helpful considerations:

There are, of course, some solutions that aim to make this process easier, such as forecasting tools and software. While none of these tools is perfect, these tools can help you (or us) analyze the relevant data and create the necessary projections. Just keep in mind that a forecast is not a prediction, it is a projection of what is likely to happen in the future based on your analysis of past performance and consideration of future trends.

The Takeaway: Start Budgeting Early

Early budgeting and forecasting is important for any law firm. By implementing a budget and regularly reviewing and updating it, law firms can gain a clear understanding of their income and expenses, identify areas for cost savings, and make informed decisions about investments and growth. For example, through effective budgeting, outside accounting firms can provide assistance in:

• Identifying and eliminating unnecessary expenses
• Identifying and taking advantage of tax incentives and deductions
• Benchmarking the firm’s expenses and vendor contracts against industry standards to identify areas where the firm may be able to cut costs.

Timely forecasting allows firms to anticipate future financial needs and make adjustments accordingly, helping them to stay on top of their finances and avoid surprises. With the right strategies and tools in place, budgeting and forecasting can be a powerful way for law firms to stay competitive and achieve long-term success. We hope this article has provided valuable insights and actionable knowledge for law firms looking to improve their financial performance.

We leave you with the following guidance from a September 1, 2021 article published by the American Bar Association:

Most solo and small firm lawyers do not have training in accounting, bookkeeping or finance. For those, it can be easy to skip the budgeting process because they feel untrained and inadequate. But those are the lawyers who most need the guidance a budget provides. Get help from a mentor, a local certified public accountant or someone experienced with business operations. Even if you need to pay for this service, it likely will not take long for an experienced advisor to tweak your budget first draft. And it will almost certainly be worth it.   

J. Bays & J. Calloway, Why Should a Solo or Small Firm Prepare a Budget? (ABA: The Finance Issue, Sept. 1, 2021)

Please note that the information provided on this website is for general informational purposes only and is not intended as legal or tax advice. The information is subject to change, and it is important to consult a specialist before making any decisions. Law Ledgers provides accounting services to New York lawyers and law firms, including escrow protection, tax advice and bookkeeping administration. Contact us today for personalized support.