A Discussion On Partner Capital

August 7th, 2008 by Jim Cotterman

A law firm recently inquired about its capital structure after its bank indicated that it considered the firm’s debt high and its capital low.  A review of the year-end balance sheet indicated the following:

Debt to Net PP&E                60%             Good is 50% - 75%; 85% is acceptable
Months Free Cash Flow    (0.10)            Poor should be at least positive 0.5, but 1.0 to 2.0 would be better
WIP & AR to Debt                  2.7               Low, should be 9.5 or higher

The debt as a percentage of net fixed assets (PP&E) is reasonable; however the pipeline (WIP + AR) as a multiple of debt is low.  At this particular firm this is primarily driven by disciplined billing and collection rather than a lack of work.  In this credit environment however, bankers are likely to be more concerned about this relationship as it indicates how much cushion exists to cover their loan.  Conclusion:  Debt is okay at its current level and is properly leveraging fixed asset investments and spreading a significant portion of the costs of those assets to the individuals who benefit from their use.

However, we did concur with the bank that the partner’s invested capital was low for their needs.  It is apparent if one looks at the Months of Free Cash Flow in the above table.  The key driver in this analysis was undistributed income at year-end.  Had the firm converted this to capital and retained the cash, its liquidity would have been acceptable (i.e. it would have internally generated a minimally acceptable permanent working capital base on which to operate the law firm).  This is an area where the firm can improve over time — probably over the next three to five years — as it is not an urgent issue, but it should be attended to.

The Discussion On Partner Capital continues in an upcoming issue of Accounting and Financial Planning for Law Firms (an ALM Law Journal Newsletter).

This entry was posted on Thursday, August 7th, 2008 at 5:26 am and is filed under Economics, Capital. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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