What challenges do the Chancellor's upcoming emergency budget pose for legal sector, particularly the VAT increase?
In order to balance the books, business has to take some of the pain of the UK's financial recovery and the Chancellor has indicated that savings will be made on an 80/20 ratio. This equates to 80 per cent spending cuts and 20 per cent increased taxes. So the increased VAT rate to 20 per cent was no real surprise. The VAT increase poses a challenge requiring law firms and barristers chambers to reflect on how well prepared they are to face the coming change. Are you confident your organisation will be in a position to manage the increase in outgoings without experiencing a temporary cash shortfall shortly after the increase takes effect in January next year?
Those with a VAT quarter ending 31st January 2011 need to account the new tax rate on sales made in January. VAT will need to be paid by the end of February but will previous invoices have been paid by then? Some law firms and barristers chambers will find themselves with a cash shortfall as a result of this 2.5 per cent increase in outgoings. The most noticeable impact will be felt by growing businesses showing a greater volume of sales in January than previous months.
So what preparation should be considered to lessen the impact?
A review of cash forecasts to ensure that the VAT increase has been included in calculations should be undertaken, followed by a revision to interim plans and those immediately proceeding the VAT rise, due to the potential for adverse cash flow impact. All businesses will experience the same pressure at the same time, therefore deferred payments by your clients are to be expected as they attempt to manage their finances.
It's important to ensure that all personnel throughout the business are informed of the situation and that planning commences now to reduce the impact of the increased outgoings. Some fee earners may be affected more than others, based on their work profile and aged debt. They need to be made aware of what can be done and how they can help to manage their forward cash position.
Whilst increasing sales volume might help finances generally, an increase in sales in the month of January itself will in fact exacerbate the problem as the VAT payable on those sales will be higher and unless bills from previous months have been paid, cash in-flow will remain unchanged
A price increase is another consideration but will clients stand such a move at present? This solution may lead to a reduction in sales volume. A team effort of action encompassing sales, marketing and cash flow management techniques is the most positive and effective approach. In order to improve cash flow management, begin by revising cash flow forecasts then formulate a plan based on what you find. It should include the following:
After revising cash flow forecasts, how can a law firm or chambers prepare for the change?
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Consider reducing payment periods for some risk categories but be aware of the potential impact on sales volume of this action. Detailed communication with clients should take place should this be one of the chosen solutions.
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Be aware of the risk being taken when opening new accounts, or extending further credit to existing clients, especially those with slow payment patterns. Ensure that due diligence procedures include a measure on financial risk and use credit checking and referencing to enable an informed decision to be made. Unnecessary credit risk taking will affect financial performance generally and cash flow specifically. A high proportion of bad debt write-offs result from first transactions. Deposits on account should be requested whenever possible, at least to cover disbursements.
Investigate which clients have signed up to the Prompt Payment Code. Some Government Departments such as the Legal Services Commission are not yet signatories, despite this being a Government initiative. -
Set targets for increased cash in-flow and engage all personnel in this initiative. Publish performance against the target monthly and produce monthly briefings which should be given face to face rather than in written form.
Monitor cash flow and Days Sales Outstanding (DSO or debtor days), considering the use of graphs and charts to clearly convey your business' current cash flow position. -
Review the billing process and talk to clients to find out how you can make it easier for them to pay more promptly. Smaller more regular bills with easily understood supporting documents may get paid quicker by some organisations, whilst others prefer a single monthly transaction, creating less administration. Adapt wherever possible to speed cash-flow. Ensure that all invoices are raised promptly and correctly. Errors lead to payment delays.
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Manage Work In Progress (WIP) closely - on a monthly basis ideally and have a process in place to communicate with individuals that do not apply billing best practice. Some of the larger organisations have begun to employ a WIP Manager as this is crucial to healthy cash flow.
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Refresh fees recovery skills. Effective actions save man hours as well as speed up cash flow. It may be appropriate to increase the hours spent on fees recovery, temporarily, in order to avert a cash shortfall in February. The expense of this will be far less than having to use a bank overdraft or obtain other external funding.
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Finally, if cash forecasts show that the 2.5 per cent increase in outgoings, coupled with falling instructions and price pressure, despite your best efforts, will still result in a cash shortfall, start talking to potential providers of funding now. Leaving relationship building out and making a last minute request will not demonstrate that you are a good financial risk.
Ensure that the cash forecast model and data provided to your lender is accurate, complete and stands up to scrutiny and be prepared to shop around for the most economic solution to a temporary cash flow problem.
How can my businesss improve its internal reporting?
When making performance comparisons, take into account the known variance. When comparing data for the first month or quarter in which the change occurs, point out the reason for the variance in the explanatory narrative. Be aware of the impact of the change when using VAT inclusive figures. When calculating DSO, separate the sales value and VAT to show an accurate trend. Failure to do so will show a worsening DSO. See the example below.
The calculation for the Days sales outstanding (DSO)
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Trade debtors (VAT inclusive at 17.5% & 20%) x 365 days
Credit sales x (1.175 or 1.20) |
= DSO in Days
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An example of the VAT increase effect on DSO
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Conclusion
Some businesses will see a reduction in profitability as a result of the increase in outgoings resulting from the VAT increase. Taking proactive steps to reduce the effect on your organisation will ensure your business survives this potential risk.
Julie Cave is Head of the Finance Recruitment and Consultancy function at LPA Legal Recruitment (October 2010)