June 27, 2008
Valuing Your Firm's Inventory
Most law firms understand intuitively that the value of inventory (both WIP and A/R) degrades over time, but by how much and how quickly? The ability to understand and answer these two questions is the first step in preparing a realistic, forward looking valuation model; one that can identify opportunities and drive action, rather than simply report on past performance.
To begin to answer the question of the future value of current inventory, it is important to realize there are two different forces diminishing a firm’s return on work performed, and both have the same basis: time. In essence the old adage “Time is Money” is true; as time passes, your inventory becomes less valuable.
The first and most basic of the two forces is widely known and easily calculated. For our purposes, we will call it the Time Value of Money effect, or TVM. A dollar today is worth more than a dollar tomorrow. Anyone who has ever used a credit card, carried a mortgage, or borrowed or lent money in any fashion, understands this concept. However, many law firms simply disregard this as a cost against their inventory, or use such a low discount rate, as to make it negligible. When considering a firm’s discount rate, too often factors such as reasonable market expectations of returns and inflation are swept aside. In the model below we use a simple method (with two different Discount Rates) to determine the cost of time on a firm’s inventory: Amount X Daily Discount Rate X Open Days; where the Daily Discount Rate = Yearly Discount Rate/365 days.
The second, and in most cases much larger charge to your inventory, is what we will call the risk of default (this refers to both defaulting on receivables and not billing work in progress). This is the risk that a firm will not realize a portion, or the entirety, of the value of work performed. In most cases it is instinctively understood that receivables a year old are far less likely to be realized than those just billed. The same can be said for WIP. But how do we measure this concept? One possible way (and there are many) is to use available historical billing and payment patterns to develop a forward expectation curve. We can then apply this curve to our current inventory to determine the amount that is realistically likely to bill or collect. This method can be made more complex or simple depending on various assumptions and the level at which the expectation curve is developed to (i.e. practice group, type of work, client, etc) but the concept remains the same — past performance is an indication of future performance.
In the example below, such a curve is constructed for a client based on a set period of time and then applied to four matters with outstanding A/R (a similar model can be built for the WIP side). A total of $200,000 has been billed over the life of this client, with $175,000 eventually being realized (or 87.5% seen at day 0). As might be expected, the majority of the collections (> 50%) have historically taken place within the first 90 days. The Fwd A/R Expectation Curve helps quantify the expectation of collection (or non-collection) as current A/R ages based on prior practices (i.e. at 240 days, $50,000 has been available to collect, but only $25,000 has been collected, giving us a historical realization expectation of 50%; therefore, if current A/R now ages to 240 days, we would expect to realize 50% and lose 50%). Of course, like any forecast, our model will not be 100% correct at each level of granularity, but it does provide a logical, and historically proven, method to value inventory, particularly at the firm level.
While simplified, the models above allow us a better understanding of a) how much of the work we have currently performed we expect to realize and b) the actual value of that work once we do realize it. Any questions, concerns, or comments on the above can be directed to Dschutz@redwoodanalytics.com.
Related posts
Filed under Blog, Cash Flow Issues, Forecasting by Derek Shutz
Leave a Comment