1. Total debt (including capitalized leases) should be no more than 100% of the net book value of the fixed assets; 90% is okay, but 80% or less is much better.

2. Lines of credit should have a zero balance at year-end and for most of the year.  The credit line should not be used to pay partners or be used as the first source of working capital.  It should be there to augment working capital, covering unusual economic conditions (i.e., negative economic performance beyond one standard deviation of norm).  An available line of credit equal to the funds required to cover one month of payroll (including owners) is one rule of thumb.

The question I get most when talking about capitalization is how much and in what form? I have two precepts. Owners should contribute meaningfully at buy-in and provide the majority of capital needs to their firms. Clearly law firms should expect meaningful financial investment from each owner. Having a seat at the table is serious business. Taking cash out of your pocket and putting it into the law firm’s is also serious business. Making a financial committment is one of the attributes of fully contributing owners.

Second, the firm should have significant liquidity. My test is probably much more severe than most. For most firms there should be sufficient cash at year end to pay out earnings, fund the retirement obligation and all payables plus two weeks of cash flow. As you might imagine, there is a fair amount of push back on these items. But a look at the profession suggests that law firms are closer than they believe to doing this. The attached chart, Balance Sheet Metrics, provides some key metrics for all firms and for the 25% most profitable firms. There are some clear differences in how the most profitable firms manage their balance sheet.

1.  The fair exchange for one’s labor—partners are very much active workers in the business.  They must be productive in fee generation both as an originator and as a timekeeper.  And they must undertake a host of non-billable activities for a modern law firm to operate well (manage, train, supervise and marketing are among a few on that list).  This is their true pay.

2.  PLUS profits from the labors of others—all other timekeepers should be profitable (generally even non-equity partners).  They are consistently and significantly profitable in the top firms.  This is their true profit.  For an interesting and related IRS view on this see my article on Unreasonable Compensation For PC Shareholders.

3.  LESS investment for growth—new people, offices, practices and markets are often funded out of current cash flow.  Since firms deduct these expenses currently they are the hidden capital invested by owners to grow the business.

4.  LESS investment for capitalized assets—items shown on the asset side of the balance sheet when there is no corresponding third party obligation for funding those assets (debt or capitalized lease obligations).

5.  LESS investment in working capital—higher salaries for associates being a prime example of a limited duration cash gap often funded by initially lower equity partner compensation.