It may seem obvious, but some lawyers need reminding: revenue has to exceed expenses in order to have cash flow.
One important expense item that has a significant impact on cash flow is the partner’s draw or lawyer’s salary. This is a touchy area for most lawyers because a lawyer’s personal style of living and expenses become important considerations in any successful cash flow budget.
To help small-firm and solo practitioners in thinking about what they need to take out of a firm as an owner, I have developed a monthly expense hierarchy:
Personal/Professional Expense Hierarchy
|Savings for the “Valleys”|
|Savings for Emergencies/Retirement||$|
This expense hierarchy shows five boxes representing the basic categories of cash expenditures. These boxes, or levels, represent the needs for cash in the order that a solo or small-firm practitioner should prioritize for the health of the firm and his own livelihood.
First come the needs of the practice. This box contains all of the expenses associated with the practice of law and the operation of your office. Why is this first? Because without the practice, there is no source for personal needs. For a hypothetical one-lawyer firm, let’s say, as an example, that such number is $8,000 per month.
Second are the lawyer’s personal needs as reflected by the draw or salary. What are all of the expenses required by you and your family to maintain your style of living? This is the box that should be the most flexible; that is, if the practice produces sufficient income, then you can increase your standard of living. But the better approach is to avoid committing yourself to extensive obligations from which you cannot retrench in time of need. Let’s give our hypothetical solo lawyer with a small family $12,000 per month.
The third box is allocated to savings for the “valleys” of the practice. During each month, some funds should be set aside to carry the practice through those leaner times experienced by every lawyer and law firm regardless of size. These valleys are typically temporary interruptions of revenues caused by either a transitory shortage of funds from clients or a temporary lull in their legal requirements that shows up as an unsteady flow of funds to the lawyer. Our lawyer puts aside $2,000 during each of six “peak,” or fat, months.
The fourth box is for personal savings for unexpected emergencies or for retirement. Too few of us are independently wealthy or maintain a second business activity that will provide ready funds for unanticipated uses down the road. Therefore, the best approach is to set aside a small sum each month and forget about it. Without getting bogged down in investment theories, interest rates, and the like, suffice it to say that because of the power of compounding interest, some sort of regular savings of even a small sum of money can grow significantly over several years. A quick rule of thumb is the “Rule of 72.” Take an interest rate and divide it into 72. That is how many years it will take for the money to double in amount. Our lawyer socks away $200 per month for ten years.
The last box is for “gravy.” After setting aside funds for each of the above categories, the balance should be considered a bonus. This is the money to reward yourself with a trip, a purchase of something special for you or the business, a speculative investment, a charitable contribution, etc.
So, our hypothetical solo practitioner is spending approximately $21,000 per month, averaged over the course of a year, in the first four boxes. If he pulls in, say, $24,000 each month in revenue, then there is an excess of $3,000 per month in gravy. If, however, our lawyer is collecting only $18,000, then something has to give, and probably it will be the variable draw (Box 2: Personal Needs).