June 2010 National Newsletter   Business Growth:  How much can your firm handle?   Written by   Andrew Chen Principal, WHK Horwath

 

At this time of year, with budgets being discussed and refined, law firms are usually contemplating how much potential there is for their businesses to grow over the next 12 months: how much can we aspire to? How much should we aspire to?

 

Here’s a thought: imagine if your firm increased the fees it bills this financial year without doing anything to encourage growth: no changes to how you operate, bank finance or partner funding.

What would your growth rate be?

 

 

5%? 10%

 

So, how do you know your firm can grow by this amount?

 

In our experience, business growth for many firms is an aspirational figure on a page, often a percentage plucked from thin air with little science to back it up.

 

We find it is rare for firms to test if their figure is really achievable. When budgeting for growth, firms tend to overlook whether their existing financial model can generate enough cash flow for them to implement growth.

 

This raises another question: do you know how much your business can grow before you need extra resources? In reality, with law firms’ focus on billable hours, there is a limit to how much your firm can grow before you need to start thinking about new staff and all the facilities that come with them – PCs, desks, phones and so on – as well as more office space.

 

Yet, it does not have to be this way.

 

There is a way you can test your growth prediction and reveal if it is mathematically possible.

 

How to test your budget for growth

The Annual Sustainable Growth Rate formula identifies how much your firm can grow without changing how it does business or its bank debt to partner equity ratio. It is really an insight to give you a sense of direction that what you want to achieve is possible, or not. What is also helpful is that the result gives you a benchmark, or KPI, for subsequent years.

 

 

Retained firm profit	=  Annual Sustainable Growth Rate
Opening partner equity

When you have calculated your result, you have two options:

 

1. Do nothing and grow anyway. You might find that your sustainable growth rate matches your budget or is higher than expected without you having to do anything, which would be great news.

2. Of course, you might find it is less than you would like. In which case, you will need to consider adopting actions to achieve growth at or above your sustainable growth rate.
 

It is important to remember that sustainable growth relies on profits being retained by your firm. If you leave no profit in the firm, your growth rate will be 0%. If, for example, your profits are going to the partners in their draw, then your growth has to be funded from elsewhere. If your growth rate is 5% and your firm aspires to 10%, clearly you will need to introduce growth funding strategies to close the gap.

Strategies to increase growth

What strategies can you use? When it comes to business growth, the options fall into one of four strategies:

 

• Raising more partner equity
• Raising more bank debt
• Increasing profitability
• Retaining more profit draws

 

For instance, you might seek to retain more profits in the firm, especially when partners leave; reduce expenses; increase your charge rates; seek debt funding, such as external investors for incorporated practices; or manage your working capital more efficiently. This includes improving your lock-up days, WIP and the number of days your debtors are outstanding.

 

An example of the variables to change your sustainable growth rate is shown in the below diagram.

The advantage for incorporated firms

For incorporated law firms, the Annual Sustainable Growth Rate works particularly well – it is clear that any firm which chooses to go through the incorporation process regards sustainable growth as a core goal.

 

One of the benefits of incorporation is that a firm can retain profits at the 30% tax rate, thereby giving it more funds to invest in growth compared to partnerships where partners are taxed as individuals. Their higher tax rate leaves them with less to invest in growth. Consequently, incorporated firms, and those contemplating it, can use their sustainable growth rate very effectively to build a strong platform for growth.

 

Let’s look at a simple example:

Incorporated firm $	Partnership $
100 income	100 income
(30) tax	(46.5) tax
70 retained income	53.50 retained income

(Assuming no drawings and opening partner equity of $100; and the partners are already on the top marginal tax rate.)

 

 

70	= 70% Annual Sustainable Growth Rate		53.50	= 53.5% Annual Sustainable Growth Rate
100			100

Of course, the million dollar question is, “how much should we retain?” It comes down to your Annual Sustainable Growth Rate:

 

1. Set your growth target using the ASGR formula. If you find the result is, say, 5% but your firm aspires to 10%, clearly you need to introduce strategies for growth.
2. Ask yourself if you can achieve your growth target using profits left in the firm. If not, you will need to source funding, and possibly reduce your costs.

 

Andrew Chen is a Principal at WHK Horwath in Sydney. He specialises in improving financial outcomes for professional services firms. For further information, please contact Andrew on 02 9619 1626 or email andrew.chen@whkhorwath.com.au
 

 

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