Cost of Goals

Continuing from last week’s contribution on building a credit policy, we continue further down the road of building the core foundation. Once the organization has established the mission of the credit department, the next step is to get a grasp on the goals of the credit department. The goals will define the end result of what is to be achieved. For many, this is seen as probably the easiest part of putting together the policy reflecting the belief, “I want to collect this amount of billings and it must happen.” However, this mindset is seriously flawed. This is a product of an isolationist mentality, basically I can want anything, but doesn’t mean I will get it. Sadly many firms begin the year with the ‘want’ and get something seriously different.

The gap established between ‘want’ and ‘received’ is a product of external forces. The components of collecting receivables are a product of internal and external forces of the organization. They are a product of everything from culture to global economics. The first step in bridging the gap is to “know thyself,” and this is much more complex than it appears. For “thyself “is a compilation of organizational culture, as well as local, regional, national and international economics and most importantly the organization’s tolerance for risk.

One’s goal for the credit policy is to have a strong understanding of the organization’s affinity for risk; that chance of loss. The risk each firm faces can be broken down into inherent and market risk. Every client in the firm’s portfolio brings inherent risk and market risk. Market risk is very easily understood; simply look at the US credit crisis (now moving through Europe). It is the probability of default as a result of the impact of the economy. However, inherent risk drives deeper; it is the cultural make up the client, most specifically the management and culture of the client. Take for instance the airline industry, all air carriers are faced with ‘market risk’. However, how are some able to maintain profitability while others can’t – culture. Those profitable airlines have a management team and culture that mitigates their inherent risk to the market place, in light of the market condition. Inherent risk is the risk that each client brings to the market by virtue of their management culture. Thus the firm’s responsibility now rests on how much ‘risk’ (market and inherent) it is willing to bear. Essentially, how much is the firm willing to lose in taking on the engagement that is the ultimate question?

The firm’s first step is to establish how much risk it can tolerate. In simpler terms, how much is it willing to write off for the sake of getting the business? By way of a couple of examples I would like to share two firms I know personally.

The risk seeking firm is located in Los Angeles and their business is based almost exclusively on defending uninsured doctors in medical malpractice suits. According to the CFO, this is a highly lucrative business line. However, the risk of default is HIGH.

Conversely, a Washington, DC firm focuses exclusively on public relations law for the Federal Government. This practice is considerably not as lucrative; however the risk of default is LOW.

Your organizational affinity for risk is essentially a trade off of probability of loss and probability of gain. The following chart pays respect to the gains and costs related to one’s affinity for risk.

There have been countless books written on understanding your client risk portfolio. My favorite is Financial Risk Analysis, by: Jerry F. Dean, CCE. The text is definitely not for the mathematically faint of heart. Dean expounds on many complex models and their relevancy to specific industries and economic climates. However, for sake of simplicity I will present a simple model using some of the variables found in the Capital Asset Pricing Model (CAPM).

The CAPM attempts to valuate the market risk of an investment. The riskiness of the investment as it relates to the market is designated ß (beta). A ß=1 establishes standard market risk. A ß>1 relates to more risky and ß<1 equates to less risky. This model, as applied to a hypothetical firm demonstrates risk tolerance as it relates to overall market risk.

As there are many economic indicators, I have chosen Gross Domestic Product (GDP) as my standard. I would caution the use of inflation as an indicator because of the current economic climate. Let’s assume that annual GDP is 3.9%. During the firm’s budgetary process it is determined that the firm seeks a 7.5% (excluding write-off or write-down) increase in profits over the previous year. Therefore, the firm’s ß becomes 1.93; the percentage return expected by the firm over GDP. To bring this into reality, if the firm’s increased profits are $375,000 over the prior year and the risk model is ß =1.93, then the firm should feel comfortable with a year end return between -$348,750 (loss) and $375,000 (profit).

Once the firm comes to the point of being comfortable with their potential loss and the range of profit to loss, then the greatest loss amount ($348,750) or X% of billings then becomes the firm’s risk tolerance. We as a firm will lose no more than X% in the coming year. From there, the X% must be allocated over all practice groups in light of billings AND economic climate (keep in mind the credit crunch). At that point, each practice group will have their thresholds set; upper 7.5% increase in billings and not write off more than X%. The final step is to adjust the X% to a per client level to adjust for the inherent risk.

It is at this point, that the goals of the firm can be clearly documented, as the firm should be well aware of their potential costs in achieving their goal.

Got Commitment?

The effectiveness in managing an organization rests on the commitment of those in management to always operate in the best interest of the organization, sometimes at the detriment of their own self interest. Within the last few months there as been a considerable amount written about lack of commitment in today’s professional services organization. I, myself, have presented a contribution as to the secrets of growing a professional services practice through committed players. Just yesterday, the Wall Street Journal published an article how a lower Manhattan firm has partners scampering to other firms because 2008 profits will be lower than expected.

Today’s professional practice has partners of various commitment levels to the overall profitability of the firm. Those on the lower end of the spectrum are the ‘bad apples’ to the firm and will pull the firm profitability down. Remember that doom and gloom disseminates much faster than excitement and fanfare. For those not committed to their firm, it is time to go searching for that pot of gold at the end of the rainbow. Firm profitability doesn’t start with the partner next door or the department head, it starts with you! You Ms. Partner must stop being involved in collections and become committed to the firm’s profitability through a strong positive cash flow.

As presented in my last contribution, a collections effort is essentially the remnants after the war has been fought or cleaning after the parade has past. Waiting until the work has been completed and billed will essentially close the doors to strong cash flow. Recall, that the collections process must be based on a policy. The collections policy must be a mirror image of the credit policy. Only then does the firm have a strong footing on which to reap a strong positive cash flow. Therefore the first step for the firm is building a credit policy.

The word ‘policy’ conjures up negative connotations of heavy bureaucracy and inflexibility. However, a well constructed policy provides tremendous value to the firm. The top four contributions a credit policy brings to the firm are: 1. It focuses everyone in the firm that client portfolio management is important and serious, 2. It ensures consistency among practice groups, 3. It establishes a consistent message sent to clients and prospects, 4. It reinforces the value of credit and collections to the firm. In building the credit policy, there are two main issues to be observed, the understanding of the firm’s culture with respect to risk and documenting how the firm will manage this risk as part of their client portfolio. The one main reference guide I would suggest to anyone seeking to build a credit policy is: How to Write a Credit Policy, by Cliff Miller. The publication is put out by the Credit Research Foundation. It is extremely well written and walks the reader through the process of creating a credit policy.

The first step in building the credit policy is to understand the credit department’s mission to the organization. This will establish where they fit in the hierarchy and their importance in the eyes of management and all partners. Keep in mind that the credit department and collections department, ideally, should be separate. The credit department’s mandate should be based on the issuance of credit based on the firm’s risk tolerance; this requires a very analytical skill set. While the collections function is more an assisting and encouraging role that works towards getting bills paid; people centric. Both of these functions are encompassed by the firm’s tolerance for risk. Over the coming contributions, the concept of risk management of the client portfolio will be interspersed with the building of the credit policy so as to provide a uniform progression toward a completed policy.

The first question the firm must answer is: What is the mission of the credit department? How this is answered will ultimately determine the firm’s cash flow. I feel the credit department must operate under the direction of the most senior of management, as this department has a tremendous impact on the firm’s cash flow. The mission statement may turn out to be the precursor the identification of the firm’s tolerance for risk. Keep in mind, that the mission statement may possibly be revised by the end of the credit policy. For once set, the credit policy will be the foundation of future cash flows. Here are some examples to seed thought:

The firm in Expansionary Growth Mode (risk seeking)

“It is our policy to provide credit to all potential applicants, regardless of payment experience. The credit department will attempt to screen out clients who obviously will become bad debts. We will attempt to build relationships with all our clients and effect collections without jeopardizing the client relationship.”

The firm who understands their affinity for risk

“The credit department is responsible for maintaining a high level of quality in the client portfolio in direct alignment with the firm’s risk profile. We will act to provide flexible mechanisms to protect the firm’s substantial investment in the client portfolio, while not negatively affecting client engagements.”

The conservative firm who has a strong market position

“The credit department is responsible for managing the firm’s investment in the client portfolio within the risk levels determined by executive management. It is our responsibility to assume no unwarranted risk. We will advise executive management of clients who become risk situations and will make efforts to limit the firm’s credit exposure in these areas.”

Once the firm has established the mission of the credit department, the foundation will be set. From there the firm will establish its commitment toward firm growth, longevity and cash flow. Firms must start with knowing what they want for the firm now and into the future.

Know thyself
Socrates

The Cash Flow Vacuum

In the last four weeks there has been an explosion of articles written on practice management issues in today’s law practice. Over this time, they have become increasingly bolder and more hostile. Although I believe it is time to make a change regarding the management of today’s legal practice, initiating change is better accepted when it is a product of educating rather than bayoneting the wounded.

All business entities whether commercial or professional services are interested in managing their cash flow. The management of cash flow, a scare resource, is the entire basis of economic modeling. Organizations, as a whole face both an inward and outward cash flow. No one would argue it is the sum of these cash flows that is of greatest interest to an organization. How organizations manage the incoming and outgoing cash flows determines their long term economic viability. Although the management of these processes is entombed with management culture and market dynamics, they can be refined.

The management of outgoing cash flow is easily for most law firms. For the most part, the organization’s vendors communicate how and when they want to get paid. For the law firm, this dynamic goes unquestioned. In all my years of working with and within law firms, 99% of the time vendor bills get paid on time. Whether it is the preservation of a sterling credit rating or the demonstration of financial worthiness, payments are made based on terms.

In today’s legal practice, however, incoming cash is not as well managed. Anyone working in today’s law firm on the collections side would easily attest that cash receipts are dictated by the client’s attitude; where the firm’s bill fits into the client’s priority structure. The important thing for today’s professional services organization is to make sure their bills are at the top of the client’s payment priority structure!

Today’s professional firms are simply operating in a vacuum in how they manage their profitability. In today’s Law.com article Should Small and Midsize Firms Create Strategic Plans? (http://www.law.com/jsp/law/sfb/lawArticleSFB.jsp?id=1202421933007), consultant John Remsen Jr. concludes “Firms often steer clear of crafting the plans because the process is "hard" work and often raises unpleasant issues”. To that I would add, for the most part attorney’s simply lack the acumen to look at the environment and the firm as an economic ecosystem.

Although most firms really don’t undertake planning, other than isolated rudimentary budgeting, there are those who do plan but very few undertake building a strategic vision. On the collections side, most firms that ‘plan’ how much money they will collect each year. However, what I have found to be the most amazing part of the ‘cash receipts plan’ is that it is made in isolation. It is built in complete isolation of the economy, the inherent risk of their client portfolio, the current inventories, and the culture of the firm. These firms rest their entire existence on, essentially a wish rather than a probable reality. This lack of planning is supported by Remsen with “… attorneys often are more focused on short-term issues rather than the longer-term outlook. They also tend to be autonomous in their thinking, and they don't like risks or change”.

Today’s firm have a multitude of interrelated issues, none of which can be resolved overnight. This is also true for commercial entites;as they too have issues. However, commercial entities tend to have more planning and strategic vision as part of their operations diet. One of the first places firms should start, I feel, is achieving a better management of incoming cash flows. Firm’s have to realize that delinquent client payment isn’t a product of a poor collections policy or staffing. It is almost entirely based on the management of risk and client intake. The management of risk must be covered in the firm’s credit policy. In my two decades of working within and around law firms, I have yet to encounter a firm that has true credit policy. Credit and collections policies are meant to work hand-in-hand to firmly ground the organizations relationship with the client; to establish shared expectations.

It is only from tightly coupling between the credit policy and collections policy that firms can establish the foundation on which to accomplish more than budgeting. Firms can begin to strategize about their future, enhance their competitive advantage to become the leader of their peer group.

Whether you (firms) like it, believe it or not – change is happening in the legal market space. Sadly a few firms are initiating change while the market is forcing change on most. Clients are becoming more disenchanted with the practices of today’s firm and the results are being manifested in depressed cash inflows. Jason Mendelson, a VC and lawyer, had this to say to Law.com in the article VC Slams Attorneys on Salaries, Overlawyering, (http://www.law.com/jsp/article.jsp?id=1202421919452) “I've been working on a thesis for quite some time that the entire business model of law firms is going to have to change, or it's going to get uglier."

The issue of having a solid credit and collections policy is, I feel, jugular to the overall financial management of the organization. In order to help firms to act, now, rather than react, later, the next several postings will focus on establishing credit and collections policies in today’s economy.