The importance of understanding the business of law firms
This shouldn’t come as a surprise to anyone: Law firms are for-profit businesses. While law schools equip students with legal reasoning, case analysis and advocacy skills, they don’t teach the business of practicing law—an oversight that can significantly impact career trajectory and success, especially in a law firm. To serve clients, firms must be financially healthy.
Whether you’re launching a solo practice, joining a small firm or navigating your way through BigLaw, understanding the financial and operational mechanics of running a law firm is essential to the successful practice of law (and may explain why partners harp on billable hours and nitpick your time entries so much).
That means generating more revenue than expenses, understanding overhead, managing cash flow and pricing services appropriately. The purpose of this installment of Survival Guide, Esq. is to explain the fundamental practicalities of law firm practice—beyond briefing cases, responding to discovery and managing clients.
Understanding the basics
Understanding the financial health of your law firm is essential for all attorneys—not just partners and firm managers. Familiarity with basic financial reports can enhance your strategic thinking and aid in making informed decisions about billing and client work.
While you may not have access to your firm’s financial reports, a basic understanding of what the partners are tracking can prove invaluable to your career development. Here are a few to start with:
• Income statement (profit-and-loss statement). This report shows the firm’s revenues, expenses and net profit over a specific period—providing a snapshot of profitability. Key line items include fees earned, salaries, rent, professional expenses (e.g., legal research vendors, CLEs, bar association memberships) and other overhead expenses. A positive bottom line indicates profitability, while consistent losses may signal operational inefficiencies.
• Balance sheet. The balance sheet presents the firm’s financial position at a given point in time. It includes assets (e.g., cash, accounts receivable), liabilities (e.g., loans, accounts payable) and equity (the firm’s retained earnings and partner capital). This report helps assess the firm’s solvency and financial stability.
• Cash flow statement. This report tracks the flow of cash in and out of the firm. A firm may be profitable but still face cash shortages if collections lag behind expenses (read: clients fail to pay timely or at all).
• Work-in-progress and accounts receivable reports. These are essential for law firms. WIP tracks billable work not yet invoiced. Accounts receivable shows billed but unpaid work. High WIP and accounts receivable can hurt cash flow if not regularly converted to revenue. This is among the reasons accurate and timely billing is so important. If you’re slow in submitting your billable time, this can delay invoicing clients, which delays the law firm’s receipt of payment from that client.
You need paying clients
Knowing how your firm earns (or loses) money helps you understand your role in the larger machine. Law firms make money by billing clients for services rendered. As mentioned above, those funds are necessary to cover, among other things, overhead expenses, including your salary, office space, computers, phones, software, subscriptions, bar dues and all that rad law firm swag. Therefore, understanding where the money comes from and how it is spent is critical to the viability of the law firm and your ongoing employment. Consider:
• Are your billable hours translating into actual profit?
• How efficient are you with your time?
• Is the client getting value from your work?
Associates are often privy to billable hours reports. It’s amazing how much information can be gleaned beyond who’s killing it and who’s slacking. For example, understanding realization and utilization rates provides insight into how efficiently your (and your colleagues’) billable hours are converted into revenue.
The utilization rate is the percentage of your working hours that are billable. While a high utilization rate may be viewed as a sign of productivity, quality and client satisfaction are equally important.
The realization rate is the measure of your recorded billable time that actually gets paid. This is broken down into two parts: (1) billing realization—the percentage of recorded billable time that gets billed to clients—inefficiencies of newer attorneys often result in write-offs or write-downs of time; and (2) collection realization—the percentage of billed time that actually gets collected.
A low realization rate may signal issues with billing practices, client dissatisfaction or timekeeping inefficiencies. Consistently high utilization with poor realization may mean you’re working hard but not efficiently. Conversely, excellent realization with low utilization might indicate underperformance. To improve both rates, focus on accurate timekeeping, clear communication with clients (internal and external) about billing expectations, and proactive follow-up on outstanding invoices. As you grow in your legal career, mastery of these metrics will help you contribute to the firm’s financial success and guide your professional development.
If you eventually want to make partner, start a practice or become a decision-maker, knowing how to contribute to a profitable business is critical. Firms don’t just promote great lawyers—they promote great lawyers who help grow the business. Indeed, client service is tied to business acumen.
Understanding the economics of legal practice makes you better at serving your clients because it lets you better understand and explain billing structures (hourly vs. flat fee vs. contingency), manage client expectations and propose value-based solutions that align with the client’s business needs and goals.
Clients want more than just legal answers—they want strategic partners who understand the cost-benefit analysis of litigation, settlements, compliance and risk.
Take courses or CLEs
Erin E. Rhinehart. (Photo courtesy of Faruki)Regardless of where you are in your legal career, start mastering these skills now. Learning about profitability, budgeting, time-tracking and client development doesn’t distract from your legal craft—it enhances it by improving your efficiency, confidence and leadership development.
In addition to asking questions of more senior attorneys, partners and mentors at your firm, consider taking a business or accounting course geared toward legal professionals. Many local, state and national bar associations, including the ABA, now regularly offer “business of law” CLE courses.
The law may be your calling, but if you want to thrive, you must also think like a businessperson. When you understand the numbers behind the practice, you’re not just a better lawyer, you’re a more strategic, empowered and indispensable one to your colleagues and your clients.
Erin E. Rhinehart is co-managing partner of Faruki in Dayton, Ohio. Her practice focuses on commercial litigation, spanning a variety of issues and industries.
Survival Guide, Esq. offers advice for early-career lawyers through a partnership between the ABA Journal and the ABA Young Lawyers Division. The authors of the column welcome any of your questions. Please send them to [email protected].
This column reflects the opinions of the author and not necessarily the views of the ABA Journal—or the American Bar Association.
