Stress tests have grown from testing for heart disease to identifying the adequacy of bank capital during periods of prolonged recession.   In the current economic downturn, a number of law firm’s have asked us to perform a “law firm stress test.” Our version looks at the strength of  a firm’s  balance sheet to determine its ability to weather financial storms such as deteriorating work levels, aging receivables and constrained credit markets as well as a firm’s ability to fund growth and invest in its future.  We examine not only the adequacy of capital but also liquidity.
 
Lessons from this recession certainly include a better understanding of how quickly credit markets, practices, work and cash flow can disappear.  Once in such a cycle an economy will experience an inverted economic multiplier.  Traditionally an economic multiplier is used to calculate how enhanced economic activity ripples through an economy such that the initial dollar spent provides far more in total economic benefit.  When inverted we see the magnifying effect on the contraction.  This is what we have been experiencing during much of this recession.  Having sufficient liquidity and capital provides the buffer to weather such conditions or at least to give leadership time to reshape the organization so that it can survive.
 
Some law firms have asked us to review their capital programs,  generally thinking about how much capital each partner should invest in the firm or how much debt they can afford to carry.  While important, the total amount invested by owners or borrowed from banks is only part of the answer.  The availability of cash must also be considered.  All is affected by a range of variables including billing and collection cycles, overhead levels, draw policies, growth needs, allowances for capital repayment on retirements and the like.

This entry was posted on Thursday, April 23rd, 2009 at 5:42 am and is filed under Economics. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.