Law firms, like any other business, need to make a profit.
But unlike many other businesses, law firms make that profit not by selling a product, but by selling time. Lawyers have to log enough billable hours to keep the entire firm in the black.
So what happens when the market fluctuates or when a firm loses clients? When those billable hours go down, how does the firm stay profitable? Or what about when lawyers on a case max out on the number of billable hours they can reasonably put in? How do you continue to meet demand?
In other words, how do you keep profits on the rise while staying ahead of your ongoing needs? What’s more, where do non-billable hours and costs fit into the mix?
That’s where law firm profitability analysis comes in.
In the world of law firms—which rely on timekeeping and hourly rates to build revenue—profitability analysis is a particularly essential tool.
In this article, we’ve teamed up with ProLytics—a consulting group with extensive experience supporting law firms with their enterprise performance management and a trusted Vena partner—to look a little deeper at why that is.
But first, what is profitability analysis in the first place?
Profitability analysis focuses on evaluating your business’s costs and revenue streams in order to optimize profitability.
Through qualitative and quantitative data analysis, this helps finance and operations teams look for new ways to add efficiencies, cut costs, track performance and better understand their client relationships. And that’s an exercise that can be particularly helpful for law firms.
Everyone in the legal space knows how key billable hours are to a law firm’s profitability. They represent the main revenue stream for most law firms, and tracking those hours is critical to any single lawyer’s success—as well as the profitability of the firm as a whole. But billable hours are just one side of what makes law firms profitable.
How your lawyers spend their non-billable hours—that is, the hours they use to grow their client base, improve their services or keep up with the day-to-day tasks of the business—are just as important. As are the costs accrued along the way.
Law firm profitability analysis takes all three elements—billable hours, non-billable hours and costs—into consideration. And it’s how you handle the last two that can often be the difference between making a profit and not.
After all, only through the right balance between non-billable and billable hours can a law firm truly thrive. And only by understanding the most effective places to spend—on technology to add new efficiencies, for instance, or on client relations to improve customer retention and word-of-mouth referrals—can you better support the business as a whole.
For law firms today, optimizing costs and getting more from their non-billable hours is more critical than ever. Like any other business, they’re dealing with market shifts and changes in demand.
According to Thomson Reuters’ 2023 Report on the State of the Legal Market, demand for transactional lawyers declined significantly in 2022, thanks to global political and economic uncertainty. The report also found that while billing rates continued to grow, expenses also remained high.
Law firms, it’s clear, need to find ways to stay profitable and agile even during these types of market shifts—and that’s where they’ll lean more heavily on their profitability analysis.
Profitability analysis pulls information from your profit-and-loss (P&L) statements and balance sheet, and from data sources across the business. There are several components to any profitability analysis, including the following.
Profitability ratios are used to determine a firm’s ability to generate profits. There are two different types of profitability ratios: margin ratios and revenue ratios.
Margin ratios help determine how much profit a firm is making or can make. They include:
Revenue ratios measure the overall revenue a firm can provide shareholders such as equity partners. They include:
For law firms, here are some of the profitability metrics that matter most:
A lawyer’s utilization rate is the number of hours they spend servicing a client during a specific period of time. Their realization rate, on the other hand, represents the number of hours the client paid for.
In some cases the ratio between the two will be 100%, but often discounts, write-offs or client dissatisfaction will mean it comes in at less. Understanding why that is will help you know where there may be issues in your client relations that you’ll need to address.
Outstanding work-in-progress (WIP) fees are the client fees that have been logged but not yet billed for. These help you get a sense of how many billable hours a particular lawyer is tracking at any given time, and whether they’re meeting their goals. But, it can also tell you how long it takes for support staff to invoice a client and how many hours are being left unbilled in the meantime.
It's only natural that the more experienced a lawyer is, the more they can charge for their billable hours. Leverage refers to the strategic allocation of tasks and responsibilities among lawyers at different levels of experience and billing rates.
In essence, it involves equity partners effectively using their team of timekeepers, which may consist of associates, paralegals, and support staff.
Equity partners' ability to leverage their timekeepers is a critical strategy for law firms to maintain profitability, control costs, and deliver high-quality legal services efficiently. It's about finding the right balance between billing rates and cost-effectiveness while ensuring that clients receive the best value for their legal needs.
One of the key ways lawyers spend their non-billable time is on client acquisition. Keeping track of the costs and time spent on networking, marketing, ads, etc., in relation to the number of clients actually converted, can help you see whether this time and money is going to good use—or if you need to make changes in your strategy.
Law firm profitability analysis involves using these ratios and metrics in concert to make revenue projections and determine whether you’re meeting your revenue goals. In turn, this helps your law firm determine where to allocate resources most strategically, how to price more effectively and how to maximize revenue potential—all while staying agile to market changes.
But all this is easier said than done.
Why aren’t all law firms undergoing profitability analysis to optimize their revenue potential? For some, there may be obstacles slowing them down. And for others, those challenges may have them giving up before they’ve truly started.
These are some of the most common challenges you may be encountering as you undergo your law firm profitability analysis—and how to get past them.
Profitability analysis relies on data stored within multiple systems across your legal tech stack—including enterprise resource planning (ERP) systems such as ProLaw, Aderant, Clio, Oracle and NetSuite; and human resource information systems (HRIS) like ADP.
With only disjointed and disorganized data sources, or messy data, to rely on, many law firms’ finance teams worry they’re setting themselves up for failure. But while clean, organized data is important—and a single source of truth can be a game changer (more on that later)—it doesn’t have to be a sticking point to getting started.
During the livestream Vena for Legal Firms by ProLytics, William Liang, Managing Director at ProLytics Consulting Group, discussed how fragmented data prevents law firms from being able to identify areas to improve performance and respond quickly to the market.
Start with a focused approach. ProLytics suggests beginning with a specific business question that will help guide your analytics process. You can test hypotheses using the data you do have and start to identify the data sources that matter most—all while evaluating that data’s quality and completeness.
Just don’t try to do too much at once—the idea is to start small and grow as you go, or you’ll only get overwhelmed.
To get the most out of your profitability analysis, you need support from across your practice, in order to bring in new efficiencies, cut costs or make other strategic changes.
That starts with your own finance team, but extends to the lawyers at your firm and goes all the way up to leadership. It’s only through that culture of support that you’ll be able to implement the strategies and changes you uncover in your profitability analysis.
But for many teams, that support is hard to find. In fact, in a piece for Thomson Reuters, Managing Partner at Maguire Schneider Hassay LLP Wayne Hassay suggested that some lawyers think focusing too much on profitability can “sully the integrity of the law.”
During the livestream Vena for Legal Firms by ProLytics, William Liang, Managing Director at ProLytics Consulting Group, discussed the importance of getting buy-in from leadership and power users when it comes to the success of introducing a dedicated tool for performance management and profitability analysis.
Again, don’t be afraid to start small. ProLytics suggests putting together a small group of stakeholders who you think will get behind what you’re doing—including project leaders and higher-ups who have the power to usher in actual change.
As you start to build that change, they’ll be your champions—sharing the progress you make. As everyone sees the benefits you’re introducing, they’ll begin to understand the value profitability analysis offers.
Putting the findings from your profitability analysis into action usually requires the participation of different departments across the organization. That might mean introducing automation technology to free up time for higher-value tasks, tracking billable (and non-billable) hours in a more timely way, streamlining billing and collections or hiring new talent to fill in the gaps.
But when departments are siloed, that becomes harder to do—making it difficult to make any progress.
Consider your change management tactics and prioritize being transparent about your goals and how you’re planning on achieving them.
Highlight your projected wins—and early wins—and how each department will be affected. After all, everyone’s invested in helping the firm succeed—and if you can find ways to do so that support and empower other teams and contributors directly, they’re sure to get invested.
As you’re ready to move forward with your profitability analysis, here are a few tips to get you started:
You don’t need to start from scratch. The right template (like this free template from Vena and ProLytics) can give you a great starting point to get you off the ground and help you understand what you should be measuring.
When you don’t have to go rooting around for the data you need, you can spend more time analyzing it. Consider opting for corporate performance management software that can integrate data from all your source systems and make it accessible to you in one place.
We’ve already covered some of the metrics law firms can use in their profitability analysis efforts, but the importance of those metrics bears repeating here. The metrics you choose to focus on will guide your entire process, so make sure you get them right—and continue to assess the KPIs you’re using to ensure they’re giving you the insights you need.
More than most other types of businesses, law firms rely on accurate timekeeping of both billable and non-billable hours to succeed. And your profitability analysis requires it too.
Contemporaneous timekeeping—that is, timekeeping that’s done immediately, not at the end of the week or some other time after the fact—is always going to be the most accurate, and the more accurate the data is the better your analysis will be.
Setting a precedent of more frequent and timely profitability analysis can also encourage lawyers to be more on top of reporting their billing.
“[Profitability analysis] was only done once a year before; we’re doing it semi-annually now with the goal of doing it monthly next year,” said Pat Carrano, CFO of Loopstra Nixon LLP on a ProLytics webinar.
“That entices the lawyers to bill monthly, because if they’re going to get a monthly profitability report, they’re going to want their numbers in there for sure. That goes away from the tradition of lawyers that like to dump 50–60% of their of their bills in December.”
By analyzing and forecasting future demand for your firm’s legal services, you can stay on top of its needs and learn how to build on your future profits. Start to track seasonal changes in demand, the complexity of your ongoing cases and so on to better understand when you may need additional staff or resources to meet future needs.
With all of the right components in place, you can start to build on your law firm profitability analysis and gain a more accurate view of your practice’s profit potential.
This enhanced visibility into—and control over—your revenue streams and costs will help your law firm thrive, no matter what’s happening in the market around you.
And your entire law team will eventually thank you for that.
Leverage this free template to gain insight into the performance and profitability of different timekeepers to make informed decisions.
