Legal update: a bump in the road on the way to recovery
Guest article written by Patricia Kinahan of Hazelwoods
In the last few months we have probably seen the most challenging time in anyone’s career in terms of how to manage a business.
There are no textbooks to refer to on how to get through this, and so we have had to rely on our own skills and expertise, and those around us, to help. It probably feels in some ways that the hard work has now been done, as there are glimmers of hope that things are starting to pick up, with the re-opening of the housing market, social distancing rules being relaxed more and more, and businesses starting to re-open.
From a finance perspective, the only real Government support for law firms is the furlough scheme, which has softened the short-term impact of COVID-19 and allowed firms to avoid widespread redundancies. All other support from the Government has really been about deferring financial issues until another day in respect of VAT, PAYE and income tax payments.
Many firms’ finances are currently in better shape than they perhaps predicted at the beginning of this pandemic. Most firms have more cash than expected, thanks to the deferment arrangements, furloughing and the push for fee earners to bill as much as possible and clear out work in progress. However, behind the scenes, with the clear down of work in progress, what is happening is that as activity levels reduce, that work in progress is not being replaced at the same rate.
Just when you are thinking that you are back on track, the reality is that there is a potential large bump in the road on the way to recovery, and this is all set to happen in quarter one of the 2021 calendar year.
What's causing the bump in the road?
The reason for this is that all of the deferment offers by the Government, which most firms took, will crystallise in that quarter. This includes the VAT payment up to July 2020, and for many, this VAT payment will be exceptionally large in comparison to perhaps what firms are paying at the moment, as it was a very busy quarter, and it will also happen at a similar time to another VAT quarter, so firms will effectively need to pay six months’ worth of VAT in one go.
In addition, there will be three tax payments to make, being the second payment on account for 2019/20 (normally payable on 31 July 2020), the sweep-up payment for the set of accounts falling in the tax year ended 5 April 2020, and the first payment on account for the set of accounts falling in the tax year ending 5 April 2021.
For firms that have a year end other than March, the second payment on account and sweep-up payment is potentially for a very good year, i.e. April, May or June 2019. Having a year end that does not coincide with the tax year is great when business is brisk and money can be put aside for tax and invariably used as part of working capital. However, when activity levels reduce after such a good year, the temptation is to use the cash generated from those profits to help the business, which then means it is not available to pay the tax when it becomes due.
Consider your options
There are many things that a firm can look at to help with tax payments due at the end of January 2021. Firms should speak to their accountants and plan in advance.
With so many businesses in a similar situation, the Government will probably offer some form of ‘time to pay’ arrangements next year, but firms should not rely on this.
The main issue that a firm needs to focus on is the balance of the rebuilding of work in progress, and how quickly that can be converted into cash, versus the cost of creating it. One of the challenges of managing working capital at the moment is that matters are taking longer to complete, and therefore the working capital cycle is being extended, which invariably means cash generation will be delayed. In the meantime, the costs of creating that work in progress will quickly eat into cash reserves.
The ability to balance this will determine how well a firm deals with the bump in the road.
In addition to this, your clients will also be looking at that first quarter of 2021 and making plans to manage their own cashflow. No doubt you will have seen a slowing down of cash collection from the initial phase of the pandemic, particularly for those firms that have commercial clients, as everyone wanted to preserve cash. This will happen again in the first quarter of 2021, and may start to happen towards the end of the 2020 calendar year. Using your creditors as part of helping you with your working capital cycle is a common practice for many businesses, but you do not want to be on the end of it!
Plan ahead and take action
So what can you do? To try and smooth out the bump that is coming down the road, there are a number of actions you can take now and continue with throughout the next twelve months:
Forecast, forecast and re-forecast
- Most firms have prepared short-term forecasts to help them through the initial phase, which has been incredibly helpful. That newly formed habit (for some) must continue, but must be pushed out on a rolling twelve-month basis. With life changing so quickly, re-forecasting on at least a quarterly basis is now required as more information comes to light.
Test your forecasts
- It is so difficult to predict what may happen in terms of activity levels across so many different areas of law. However, you should always test your forecasts by applying a level of sensitivity. A good rule of thumb is a reduction of income of 20% to see what the impact is, and therefore you can be ready to make decisions when you start to see this decline.
Carefully monitor people returning from the furlough scheme
- It is easy to say someone is busy, but the definition of busy has to meet the level of contributions an individual/team is making to the business. Un-furloughing a person too early, who is not going to build up sufficient billing, is going to be an expensive process. Un-furlough too late, and you may find that there is too much work for other people, creating morale issues (which can be harder to detect when individuals are working more remotely), so it is a fine line to draw. This is where looking at daily/weekly chargeable time is important.
- Furlough has helped in the short-term, but it will stop completely at the end of October. There have to be alternative measures, such as reduced working hours, pay cuts or a continuation of pay cuts, as many have happened already. This may apply across the whole firm or it may apply in different departments. The most important thing is to match activity level with demand, so that you can manage the cost of producing the work in the most efficient way.
As the saying goes, ‘forewarned is forearmed’. This bump in the road is going to happen, and it is better to be aware of it and plan for it now. There are steps you can take to smooth it out, but those actions have to be looked at now with a plan put in place, and more importantly, have flexibility in that plan to change. If COVID-19 has taught us one thing, it is the ability to remain flexible at all times as things are constantly changing, and the best firms are those that are able to adapt when required.