29 June 2022 Mini Series: The Business of Law Firms - Profit

Mini Series: The Business of Law Firms​

Profit​

Overview​

This article is the second in a series on the Business of Law Firms. Last week, we looked at the basics of an income statement by examining Clifford Chance’s most recently published accounts. Specifically, we considered the importance of revenue and expenses and discussed how they are broken down and accounted for.

Today, we will have a look at measuring profit by looking at two ways firms measure profit.

The goal is to further your familiarity with business accounts, which is an important commercial skill, while simultaneously supplementing your understanding of the key drivers of a law firm.

Accounts: Measuring Profits​

The simple measure of profit is total revenue minus total expenses. In practice, as we saw last week, not all sources of revenue are as important as others, nor are all expenses given equal importance. Therefore, most business accounts will measure profit in several ways. We will look at two this week.

For CC, we have copied its most recent consolidated income statement below.

Operating profit​

Operating profit is essentially all revenue derived from the core of the firm’s operations, minus all expenses that directly arise from the firm’s operations. This figure therefore gives you a quick sense of the underlying success of the law firm’s performance. (The same principle holds true for all businesses.)

For analytical purposes, when comparing past and present performance for a single firm, if operating expenses have increased without any corresponding increase in revenue, this suggests that the business is not growing at an adequate rate to account for increased expenses. The firm may need to consider raising prices and increasing the amount of billable work.

Operating profit (along with operating income and expenses) is a helpful tool when comparing performance across different law firms in the same market. This is because these figures do not typically include non-core sources of income (e.g., any proceeds arising from the one-off sale of valuable assets like property) or one-off expenses (e.g., a substantial regulatory penalty). Instead, operating profit tells you how efficient the underlying business is.

Profit before tax and members’ remuneration​

This figure is operating profit minus net finance costs. What are net finance costs? This is where it is necessary to check the accompanying notes to the accounts.

On p. 31, we see that note 8 details what Clifford Chance includes in net finance costs. This includes £4m paid to pensions, £13m in finance charges on leases, £3m in income from subleases, and £3m in annuities. In other words, these are all expenses (and income), it considers incidental to its core operations.

As you can see for yourself, each of these items under net finance costs has its own explanatory note. But in general, finance costs are the expenses (and income) that come from certain non-core operations. A big one is the amount the firm pays for its office leases around the world. These are not considered core expenses due to certain accounting principles.

This profit figure therefore gives a clearer picture of how much of the firm’s revenue is spent on financing, in addition to core expenses. When comparing different businesses in the same sector (e.g. another Magic Circle law firm), this figure can give a better indication of the efficacy of the firm’s wider financial management strategies.