Why cash flow is different for law firms

Most professional services businesses earn a fee, raise an invoice and collect cash within 30 to 60 days. Law firms often do none of those things in that sequence or on that timescale. Work in progress (WIP) accumulates for months before a bill is raised. Bills are raised and then not collected for months more. Client money sits in a segregated account that the firm cannot touch. Partner drawings go out before profit is distributed. The result is that a profitable firm can run genuinely short of cash.

Understanding your cash position requires tracking three separate pools: the office account (where the firm's own money lives), the client account (where client money is held under the SRA Accounts Rules) and WIP (unbilled time and disbursements). Only the office account is available to meet the firm's own obligations. The other two are either locked away or not yet invoiced.

WIP and lock-up days

Lock-up is the single most important cash-flow metric for a law firm. It measures how many days of revenue are tied up in WIP and debtors combined.

The calculation is straightforward:

  • WIP days = (WIP balance / annual fee income) x 365
  • Debtor days = (debtor balance / annual fee income) x 365
  • Lock-up days = WIP days + debtor days

Industry benchmarks vary by practice area, but as a general guide: high-street firms average 120 to 180 lock-up days. Top-performing firms typically operate below 90 days. Every extra day of lock-up represents fee income that has been earned but not yet converted to cash. At £2 million annual fees, the difference between 90-day and 150-day lock-up is £328,767 of cash tied up unnecessarily.

The main levers are billing promptness (how quickly WIP is turned into an invoice after the work is done) and collection speed (how quickly invoices are paid). Both are controllable.

Billing cycles and aged debt

Most firms under-bill, not because the work has not been done, but because billing is treated as an administrative task rather than a financial discipline. A matter that has been running for six months has almost certainly generated enough WIP to raise an interim bill, and most retainer and engagement letters permit this. The question is whether the firm's billing processes actually drive it to happen.

A practical minimum is to review all WIP over 60 days old at the end of every month and require a billing decision on each file: bill it, hold it (with a documented reason) or write it off. Files with no decision default to the first category.

Aged debt is equally important. A debt that is 90 days old is significantly harder to collect than one that is 30 days old. Firms that do not chase aged debt systematically find that write-offs creep up as a percentage of fees billed. A monthly aged-debt review with a clear escalation path (statement at 30 days, phone call at 45, formal demand at 60, referral to a debt specialist at 90) recovers materially more than a passive approach.

Realisation and utilisation rates

Two related KPIs are worth tracking alongside lock-up:

Utilisation rate is the percentage of chargeable capacity that is actually billed or recorded as billable time. A fee-earner with a 1,400-hour annual target who records 980 chargeable hours has a 70% utilisation rate. Rates below 65% typically indicate structural capacity problems: too much non-billable work, poor time-recording discipline or inadequate workflow.

Realisation rate is the percentage of billed fees that are actually collected, net of write-offs and discounts. A firm that bills £1 million but collects £860,000 after write-offs has an 86% realisation rate. High-performing firms target above 90%.

Both metrics are best tracked at fee-earner and team level as well as firm level. Aggregates hide problems that individual-level data makes obvious.

Partner drawings and profit distribution

In a partnership or LLP, partners are not employees. They do not receive a salary in the conventional sense; they draw against anticipated profit share. The timing mismatch between drawings (which go out continuously) and profit (which is calculated once a year, or quarterly at best) creates a structural cash-flow risk.

If drawings are set too high relative to actual profit, the firm enters the year-end calculation with a deficit that must either be funded by borrowing or recovered by reducing the next year's drawings. If profit is lumpy (common in litigation and project-based practices), drawings set in January may prove unsustainable by October.

A sensible approach is to set monthly drawings at 70 to 75% of each partner's expected profit share based on the prior year, review quarterly against current-year performance, and distribute the balance once the annual accounts are finalised. This leaves a buffer against underperformance and avoids the need to claw back drawings already paid.

Where the firm has a salaried-member structure (members whose position under the ITTOIA 2005 s.863A salaried-member rules means they are treated as employees for tax), the PAYE timing is fixed: monthly, with employer National Insurance at 15% on earnings above the £5,000 secondary threshold. Budget for this separately from equity partner drawings.

VAT and cash-flow timing

VAT-registered firms (registration threshold £90,000 annual taxable turnover) pay VAT to HMRC on a quarterly cycle. The practical effect is a substantial periodic outflow: a firm billing £2 million a year in VATable fees at 20% has a quarterly VAT liability of approximately £100,000 on standard accounting (more if all the VAT was collected in the quarter; less if some bills remain unpaid).

The cash-accounting scheme allows firms to account for VAT on the basis of cash received and paid rather than invoices issued and received. This is directly beneficial for firms with slow-paying clients: you do not pay VAT to HMRC until you have collected it from the client. Most law firms are eligible if taxable turnover is below £1.35 million. Above that threshold, standard accounting applies and the quarterly VAT outflow must be planned for explicitly.

The practical discipline is to hold VAT collected in a segregated current account or a named reserve. Treating it as available working capital and spending it is a common reason firms face a VAT crisis at quarter end.

SRA client money and office account separation

The SRA Accounts Rules (particularly Rule 4) require strict segregation of client money and office money. Client money held in the client account is not the firm's to spend: it belongs to clients and must be available on demand. Treating client money as a liquidity buffer is a serious regulatory breach.

The practical cash-flow implication is that the firm's office account must be sized to meet all office obligations on its own: wages, rent, PAYE, VAT, supplier invoices and partner drawings. Client receipts received in anticipation of disbursements cannot be used for office purposes until the disbursement has been incurred and the residual balance transferred to the office account.

Disbursements paid from client account must be incurred for the specific client whose money is held. A firm that uses one client's client-account balance to fund another client's disbursements is breaching the Rules, regardless of its intention to rectify the position.

Bank facilities and working capital

Law firms with long lock-up cycles frequently need a working capital facility to bridge the gap between work done and cash received. The main options are an overdraft facility, a revolving credit facility, and invoice finance (discounting trade debtors against a facility with a bank or specialist lender).

Banks lending to law firms focus on the quality and age of the WIP and debtor book, the firm's lock-up trend (improving or worsening), partner capital ratios and the firm's regulatory standing. A firm with a high lock-up and a deteriorating realisation rate will find facilities expensive and increasingly hard to obtain. The best time to negotiate a facility is when you do not need one: when cash is healthy and the metrics are strong.

Firms approaching the point where drawings exceed available cash should act early. Waiting until the overdraft is at its limit removes negotiating room and concentrates the bank's mind on risk rather than relationship.

Building a twelve-month cash-flow model

A twelve-month rolling cash-flow forecast is the most practical tool for managing practice finance. The accompanying Excel model covers the core structure:

  • Opening WIP balance and movements
  • Fees billed in the month
  • Cash collected from debtors (using a collection lag based on your actual debtor days)
  • VAT collected and VAT payable
  • Fixed costs (rent, wages, PAYE, insurance, subscriptions)
  • Partner drawings
  • Closing cash position

The key variable is the collection lag. If your average debtor days are 60, only fees billed two months ago are being collected in the current month. Fees billed this month will not appear as cash for another two months. This simple timing assumption, applied consistently, produces a materially more accurate forecast than one that assumes immediate collection.

The model is a planning tool, not a substitute for management accounts. Update it monthly using actual figures, and treat any month where the closing cash position is negative as a trigger for action rather than an interesting projection.

Key ratios at a glance

For a quick health check, the ratios that matter most are:

  • Lock-up days: aim below 90; above 150 is a serious warning sign
  • Realisation rate: target above 90%
  • Utilisation rate: target above 65% for fee-earners
  • Partner drawings as % of expected profit: keep below 80% until year-end confirmed
  • VAT reserve: should always equal or exceed the next quarterly liability

These figures are starting points, not universal targets. A conveyancing practice with high transaction volumes and low per-matter WIP will have different norms to a commercial litigation practice with multi-year cases. Compare against your own trend over time, and against practices of a similar size and type.