10 August 2022 Mini Series: The Business of Law Firms - Balance Sheet Liquidity

Mini Series: The Business of Law Firms - Balance Sheet Liquidity​

What do you need to know this week?

Welcome to the seventh article in our series on the Business of Law Firms.

Last week, we looked at the purpose of the balance sheet, which is to give a sense of a business’s underlying value. We also considered how it is different from an income statement, which is concerned with profitability (rather than value).

This week, we will further inspect Clifford Chance’s balance sheet to see what it reveals about its liquidity, which refers to a business’s capacity to pay off debts when they come due.

Below is a restatement of Clifford Chance’s balance sheet, found at page 13 in its annual accounts ended 30 April 2021.



Assets and Liabilities: Current and Non-Current

Last week, we defined assets as any sort of property that holds value, such as land and machinery. Accountants group assets into two classes; non-current and current. For service businesses like law firms, current assets include receivables (£457m), which is work the firm has undertaken and billed the client for but not yet been paid. Accrued income (£305m) is work undertaken but which has neither been invoiced nor paid. For Clifford Chance’s Financial Year 21 accounts, these two assets account for more than 60% of its current assets, demonstrating their importance to law firms and other professional service businesses.

All current assets have in common the fact that they are treated as being like cash: that is, they can be “realised” and converted into cash — sold in the case of goods held and demanded in the case of a debt owed. This explains why cash is treated as a current asset, which may also include liquid investments like shares and bonds (£370m).

Non-current assets — sometimes called fixed assets — are assets that Clifford Chance is not likely to dispose of in the year. These include IT and office equipment as well the economic value of any long-term leases Clifford Chance has negotiated.

Similarly, liabilities are also divided into current and non-current. Current liabilities are those obligations Clifford Chance must settle within the next 12 months from the date of the accounting period (i.e. before 30 April 2022). As you can see, ¾ of the current liabilities refer to trade and other payables, which are itemised at note 17 and includes money owed to suppliers, certain taxes, and “earnings due to non-members” (i.e. staff wages). Current liabilities also consist of upcoming lease payments. For businesses with outstanding loans, any upcoming principal and interest payments would be reflected under current liabilities.

Non-current liabilities are any obligations not due before twelve months. For Clifford Chance, this largely includes pension and lease liabilities, as well as capital owed to partners. If the firm had any outstanding loans, the long-term balance of the loan would be included under non-current liabilities.

Using the Balance Sheet to Determine Liquidity

In addition to signifying a business’ underlying value, a balance sheet can also tell us about the degree to which a business can meet its liabilities.

Importantly, the balance sheet starts with non-current assets and moves down to current assets and then current liabilities, ending with non-current liabilities. In terms of liquidity, we can get an approximation of a business's ability to meet its debts by subtracting current liabilities from current assets, which for Clifford Chance is £645m. In other words, if the firm needed to pay off all current debt at once, it could do so with £645m in assets to spare.

Why is this important for your interviews?

Compared to other industries, law firms (along with professional service businesses more generally) tend to be more liquid. That is, the business model does not require many valuable fixed assets in the way that an oil and gas or manufacturing business might. Instead, it has a steady stream of cash arising from billable work (represented as current assets on the balance sheet).

On the other side of the equation, law firms do not usually borrow as much money from lenders as other businesses. This is both because their steady income streams mean they do not need loans to help with cash flow, nor do they have to borrow to acquire expensive fixed assets. Instead, most of their liabilities relate to paying wages and other regular expenses (e.g. rent and bills).

As a result, law firms tend to be highly liquid, not capital intensive, and not leveraged. This means that properly managed law firms should not face difficulties meeting their obligations as they come due.

Analysing a balance sheet to determine liquidity as we have done this week may be helpful in case studies. More generally, understanding the importance of liquidity for law firms and businesses in general will distinguish you from other applicants.