What is stress testing and why should law firms do it?

By Peter Noyce, Menzies LLP and Colin Blessley, mr3 Turnaround (interviewed by Sarah Perry)

Stress testing, to use its generic definition, is a method of testing the stability of a system or entity. It involves testing it beyond its normal operational capacity (often to breaking point) to observe the results. The process is referred to by industrial users as the “torture test” – a term perhaps that may resonate with law firms at present.

Stress tests are designed as a risk management tool to evaluate the potential impact on any business of unlikely, but plausible, events or movements in a set of financial variables. The legal sector may well say what further possible events could they be hit by.

As we all know, the SRA states that the financial stability of law firms is a priority for them. It should, of course, also be a priority for the firms themselves and the solicitors within them. Principle 8 of the Code of Conduct states that solicitors must “run your business or carry out your role in the business effectively and in accordance with proper governance and sound financial and risk management principles”.

We should state that stress testing is recommended for positive as well as negative events.

Law firms looking to grow organically or through acquisitions should be considering whether they have the productive capacity and the internal systems (both IT and administrative), as well as managerial capability to cope with the influx of new work, otherwise service levels will fall and new clients will soon become ex-clients.

The flip side of this scenario is that, where firms would (hopefully) have produced projections for their practice, they need to understand what happens if turnover expectations are not met. The first thought is often “we might not make the profit we expected”, but potentially more importantly thought should be given to: “what effect does that have on our cash?”

What areas should be stress-tested?

The following are among the most important areas to stress-test.

Turnover

What would happen if turnover reduced by (say) 10%/20% or increased by 20%?

Service lines

Look at each work area to assess the effect should individual departments’ performance and billings be reduced by 10%/20% or increased by 20%, and ensure each department head has their own plan of action.

Cash

What if our work in progress (WIP) and debtors turnover (ie how quickly debtors are turned into cash) management becomes less efficient – when will our pinch points arise as regards cash availability, facilities and meeting our covenants? It is crucial to have an integrated cash flow forecast so that any effect can be flexed to assess how sensitive cash availability is.

Staff costs

At what point do we need to take action, whether it be recruitment or commencing redundancy programmes?

Premises

Are our existing premises arrangements suitable/flexible enough to deal with potential increases and decreases in our practice? This aspect would look at both the financial effect and space availability.

External/macro influences

Not unusual in the legal sector and cannot always be anticipated, so all the more reason to use stress testing and, perhaps, build in a margin within partners’ drawings so that not all forecasted profit is drawn out. The ultimate test of any profit is when it turns into cash. This is why stress testing should not focus just on profit but on cash. Many profitable firms have gone bust because the cash ran out.

Technology

Is a key part of any professional practice these days, whether upgrading computers or a customer relationship management (CRM) system. Can the upgrades planned be accommodated within cashflow and, to ensure business efficiency, can we afford to not?

How do law firms undertake stress testing and how often should they do it?

At Menzies we see many firms that often go half-way towards a decent approach to stress testing their own practice, but do not actually put in place the remedial actions required following the exercise. That is why we are often asked to be that outside voice to enforce internal messages. It may be the firm as a whole is doing ok, but one particular department is holding them back, hence the point above about stress testing all departments – you could have one department having staff sitting around while others are too busy to cope. An external specialist opinion can provide credibility to force the change internally.

Many firms produce one or two year projections, but do not revisit these at all during the period and get nasty surprises as a result. An independent opinion can be useful in ensuring that adequate reviews of progress against projections are carried out. This is also encouraged by the SRA. Then ensure the revised plans are adequately communicated internally so there is a focus and buy-in from all interested parties on what needs to change or be achieved. Often a behavioural change in teams or individuals will be required – this will only be achieved if key staff members share the strategic vision. External training and specialist help may be required. The regularity of how often you should revisit your forecasts, not just for profit but also for monitoring the cash position probably depends upon how close you as a firm are to the pinch points referred to earlier. If you have a buffer to be able to cope with the unexpected, then great, but if logging on to your bank account first thing each morning is a form of torture, then daily may be the answer.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

First published on Lexis®PSL Practice Compliance.

Filed Under: Practice of Law

Relevant Articles
Area of Interest