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

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 t

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