Do You Realize How Much You're Billing?
by Ed Poll
One of the hallmarks of the law is that lawyers often use specialized terms for common-sense ideas. A good example of this is the realization rate.
Realization is simply the percentage of what is billed that is actually collected. For example, a coaching client called me recently and talked of billing out $150,000 in a recent month, but collecting only $90,000. That is a realization rate of 60 percent.
In any business, if you collect 60 cents on the dollar, you are going to face problems in short order. The same is true in the legal profession. Too many lawyers think that financial success means ever-rising billable hours. The truth is that an attorney's inventory is not billable hours; it's the amount of cash that is realized from the billable hours outstanding.
Realization is sometimes discussed in two levels: percent of billable to hours billed (billed to billable ratio), and percent of billed work collected (collected to billed ratio).
The goal is to have a high collected to billable ratio. An overall realization rate of less than 80 to 85 percent is a recipe for trouble. An overall realization rate of close to 100 percent may have a paradoxical meaning — either that the lawyer is excellent at collecting what is owed, or that the attorney's rates are so low that clients pay quickly because the amounts are not burdensome to them.
In today's business climate, no one should look askance at a high realization rate. But the issue of whether, when recession abates, rates could be increased is one to keep in mind.
Once billables are realized, there are two methods for keeping track of them: accrual versus cash accounting. Accrual records reflect income irrespective of whether cash has been collected. In other words, accrual accounting reflects billings, work in progress (completed but not yet billed) and accounts receivable (work billed but not yet collected).
Cash accounting, on the other hand, reflects only collections, never billings or work in progress. Almost all small law firms operate on a cash basis, accounting for cash as it comes in and goes out. Larger law firms maintain both cash and accrual records.
It is possible to estimate the progress of realization by using the accounting measure of turnover ratio: accounts receivable balance divided by the result of billings per days in the billing period (either monthly or annually). The turnover ratio tells a lawyer to expect payment for billings X number of days after a client receives a statement.
The national average for law firms, according to past surveys, is often as much as 150 days. In other words, a typical small firm should have funds sufficient to operate for at least five months on the expectation that the money will take that long to come in.
Of course, it's vital to do everything possible so that turnover is not so high; the longer a billing is outstanding, the less likely it is to be realized short of turning the matter over to a collection agency.
These hard numbers unquestionably require discipline and planning to manage. Return to our example of the lawyer with the 60 percent realization rate. If you realize only 60 percent of what you bill, in order to survive you will need to treat that 60 percent as 100 percent of your income.
In other words, all your financial decisions will need to be based on the money actually collected, not on the billings sent out. If you can run your business on the 60 percent, that would be fine, but few lawyers can.
The lesson is obvious: Lawyers must vigilantly focus their energy on collecting what they bill. Failure to do so will cause personal economic failure. Unlike good wine, accounts receivable do not get better with age.