For a law practice to thrive and make practical, informed business decisions, it must have the financial stability to keep it afloat. That starts with strong financial statements.
The profit and loss statement (P&L) is one of your business’s most important financial statements. It’s used to measure the health of your business by showing you how much money you have coming in and going out. It helps you figure out if you’re making a profit or not—and what kind of profit that might be. P&Ls come in various shapes and sizes, but they all have similar components:
- Gross revenue.
- Operating expenses.
- Operating profit (or loss).
- Non-operating income (if there is any).
- Net income/loss.
When a law firm’s revenues exceed its expenses, this is called profit. When the reverse occurs, it is referred to as a loss. A law firm should always strive for a healthy profit margin, which can be achieved through solid financial reporting.
Gross revenue, or the top line of your firm’s P&L statement, is the total amount of money your firm brings in over a given period. In other words, it’s the first number on your income statement.
Operating expenses are the cost of running your business. They include rent, employee salaries, insurance, technology, and supplies. These operating costs must be paid out of the firm’s revenue (i.e., they aren’t paid for with partner contributions or client retainer fees).
On many P&Ls, you’ll see a line item called depreciation expense that is typically shown as a negative number—this number represents how much money was spent on capital investments (such as computers) during the year that has already been written off against taxable income and thus can no longer be depreciated under IRS rules.
Operating profit is the difference between gross revenue and operating expenses. It’s a positive figure that indicates how much money your business has left over to pay yourself, your employees, and any creditors you may have.
That’s pretty straightforward. But wait! There’s more: Operating profit is sometimes referred to as EBITDA (earnings before interest, taxes, depreciation, and amortization). The calculation for EBITDA is almost exactly the same as for operating profit—it just includes some additional costs (interest on debt) in its calculation of net income:
You may be surprised to learn that your firm’s non-operating income is actually a mix of revenue from various sources, including investments and debt financing.
The third component of non-operating income is the sale of assets. For example, if you sell an office building or other property owned by your firm, this would be considered non-operating income.
Finally, there are times when a law firm will sell its business as part of a merger or acquisition transaction. This also counts as non-operating income when it happens within one year after the date on which your company acquired the target company (i.e., when it acquired its merger partner).
Importance of Financial Statement
Financial reporting gives you a deeper understanding of your company’s cash flow and other business needs. In addition, some more specific areas can be examined through a P&L statement and other documentation.
It’s important to stay on top of your expenses and returns. Bookkeeping is more than just something you do for your P&L statements, it’s critical for your business overall. Many companies hire professional bookkeepers to keep track of their money, while others use software like QuickBooks or make do with custom solutions.
Profits and expenses are categorized to help you see how your business is growing or shrinking. The categories will vary depending on your practice and the types of cases you take on. Still, some common themes are employee salaries, real estate, marketing and promotions, operating expenses, licenses, travel, and administrative expenses. You’ll also need to track subscriptions, contractors or outsourcing fees, retainers, client fees, and more.
Your law firm will need to determine which categories are most important for its purposes and customize its financial documentation accordingly. A tailored P&L statement will allow you to strike a balance between the flexibility of software programs that can track every imaginable expense, and the ability to maintain a clear picture of how your business is doing by focusing on only the information you require.
Knowing the basics of a profit and loss statement can help you make more informed business decisions.
Profit and loss statements are essential documents in your law firm. You can use them to see how well your firm is doing, and they will tell you which areas of your law practice need more attention. For example, if your billable hours have been falling for months and this trend appears to be continuing into the future, then it’s time to figure out what’s going wrong with your billing system or hiring process. Suppose a particular project is costing more than expected. In that case, it might be time to reconsider whether the client should pay extra for those additional services or whether you should work on another project instead.
Here are some tips for staying on the positive side of the ledger. First, make sure that you have the financial tools necessary to keep a close watch on your firm’s bottom line. If you’re using accounting software, make sure it has all the features you need. Also, be sure to keep an eye out for new technology and additional means, methods, and tools that can assist you with a wide variety of profit and loss scenarios.
The most important takeaways were that gross revenue is important to watch when making business decisions and that non-operating income can be a valuable source of income for your firm. Financial monitoring is an essential aspect of business management. Profit and loss statements are just one of the financial tools available to you, but they’re critical as they can help you monitor your cash flow and make better business decisions.