Understanding your law firm’s profitability is key to operating a thriving and sustainable law firm, but profitability analysis can be challenging with so many different ways to evaluate your profit. The truth is, there is no “correct” way to measure law firm profitability, and the best firms actually take several different approaches to arrive at a complete profitability analysis. Today, we’ll share some of the key components to running a profitability analysis for your small law firm and explain some different ways of interpreting your results.
The first step in law firm profitability analysis is to choose what method of analysis to use.
The two methods for analyzing your law firm’s profitability are absolute and relative. An absolute approach is the method you should use if you want to find out whether your firm was profitable during a given time period or to evaluate the profitability of a specific service or partner of your firm. The relative approach, on the other hand, is concerned with benchmarking. The relative analysis method is used to measure your profits against other firms in your niche or area or your current financial projections. For most law firms, approaching profitability analysis from both an absolute and relative point of view will give the most accurate and useful results.
What are the key components of profitability analysis for law firms?
When evaluating your law firms’ profitability, you’ll need to collect data on a few important KPIs. These KPIs will make up the universe of data that will tell the story of your law firm profitability. The KPIs you want to collect in order to run a complete profitability analysis are:
- Gross profit margin
- Net profit margin
- Utilization Rate
- Billable hours
- Client Acquisition Cost
- Realization Rate
- Accounts Receivable Aging
- Work in Progress (WIP)
- Cost of Goods Sold
Every law firm’s profitability analysis will look different, so you may measure additional KPIs or choose to ignore some of these KPIs in your process. The important thing is to choose KPIs to evaluate that will help you take action to improve your law firm’s profitability.
Can I use profitability analysis law firm software?
If you want to avoid manually compiling all of these KPIs, we highly recommend utilizing project management software that helps make collecting these KPIs easier. A few we recommend are Clio, LeanLaw, and My Case. For help choosing, check out our blog about the features of each of these tools.
How to perform a profitability analysis to measure law firm profitability
Once you are able to compile these KPIs, you’ll want to start with an absolute profitability analysis. This is the best way to evaluate your firm on a baseline level without bringing in too many outside factors to start. During this process, you want to take a close look at each of your KPIs and determine each of their impact on your law firm’s profitability. This might involve asking yourself questions like:
- If my Accounts Receivable is moving slow, how are cash flow limitations affecting my ability to invest in growth?
- How does my utilization rate compare to my realization rate and what can I do to reduce that gap?
- Is my team’s productivity on Work In Progress (WIP) impacting our ability to add new clients and continually generate more profits?
- How can I reduce my Cost of Goods Sold?
What questions you ask will largely be determined by your specific goals. However, it’s important to comb through these KPIs thoroughly, evaluating each for their impact on your bottom line.
What is the average profit margin for mid size law firms and small law firms?
Once you’ve completed an absolute profitability analysis, you’ll probably want to measure your profitability as relative as well. Compiling benchmarks on each of your fundamental KPIs will help you understand how your firm stacks up against others in your area or niche. Start by looking at your profit margin, as this is the most basic KPI to compare. Experts say that a desirable profit margin range for law firms is thirty-five to forty-five percent. However, you should work with a qualified professional to provide better benchmarks based on your local and practice area competitors.
