Naturally, the purpose of many a business would be defined in some form of profitability objective. Over half a century ago, Peter Drucker wrote: "Management must always, in every decision and action, put economic performance first. It can only justify its existence and its authority by the economic result it produces".
In his case, Drucker was talking about not only profitability, but the maintenance or improvement of the "wealth-producing capacity of economic resources" in the business.
Maximising profits was not, for him, the main goal of management – for him, profit was the result, not the aim.
In simple terms, profit is what is left over from business income after all the business expenses have been paid. To increase profit, therefore, a manager must maximise revenue or minimise expenses – or both. Simple, eh? But there is more to it and we can show you how.
Profitability and Liquidity
Making a profit and having enough cash to continue to operate are often referred to as ‘profitability’ and ‘liquidity’ respectively. Profitability is the ability of a business to generate profits in relation to the amount of capital employed in the business. Liquidity is the ability of a business to meet its debts as they fall due. But you knew that!
Equally, you know that profitability is essential if, in the long term, a business is to survive – continual losses are almost certain to cause the eventual collapse of any business. But profit alone is no guarantee of success, the business must, at the same time, be liquid. Every year there are a large number of firms that collapse while making a profit because they get into a position whereby they cannot continue to pay off their commitments. Both profitability and liquidity are essential for the continued survival of any business. OK. So far, so what?
Health and Hygiene – how does your firm perform?
The reason so many firms have financial management that emphasizes only parts of the profitability formula is that their control systems are de¬signed to focus on short-term profitability (what may be termed ‘hygiene’), and ignore the issue of ‘health’ (i.e., increasing the fundamental profit potential of the firm). This is a broader management responsibility.
What this reveals is that improving profitability has two distinct management components. Some elements (predominantly short-run ‘hygiene’ issues) get over-managed, and many (long-run ‘health’ issues) are under-managed.
In essence law firm profitability is the result of ‘RULES’:
- Rates
- Utilisation
- Leverage
- Expenses
- Speed
Theoretically, no one of the five is more important than any other. In practical terms, it may be much easier to effect a change in one than another, but all five factors must be managed carefully. While some may say, “the key to profits is leverage” or “the key to profits is utilization”, there are five keys. One or more may be chosen as the main strategic thrust for the firm, and the choices change from time to time, but none may be neglected.
So, if you feel you’d like to ‘make a lasting financial impact in your firm’ – and get a handle on practice finance – then speak to your Connect2Law Hub.
