One of the key financial decisions confronting law firms is the choice between settling Corporation Tax, VAT or Self-Assessment tax liabilities with cash or opt for finance. Conventional wisdom advises earmarking funds and paying tax liabilities from savings. However, a crucial yet frequently overlooked financial metric in this decision-making process is the Return on Capital Employed (ROCE).
ROCE is a key financial metric that measures how efficiently a law firm generates profits from its capital. By understanding ROCE, a law firm can make informed decisions about whether to finance operations through borrowing or by using their own cash reserves. This article explains how ROCE can show the cost benefits of borrowing money instead of using a law firm’s cash reserves.
What is ROCE?
ROCE is calculated using the following formula:
Return of Capital Employed = Earnings Before Interest and Taxes (EBIT) / Capital Employed
Capital employed typically includes total assets minus current liabilities. A higher ROCE indicates that the company is effectively utilising its capital to generate profits. This metric is particularly useful when comparing the performance of companies in capital-intensive industries.
For a law firm, ROCE is measured in terms of super-profits as a percentage of partner capital in a partnership or LLP or retained profits and share capital in a limited company.
The Cost of Capital: Borrowed Money vs. Own Cash
When businesses need funds for operations, expansion, or other investments, they generally have two options: using their own cash reserves or borrowing money. Each option comes with its own set of costs and benefits.
Borrowing Money:
Interest Payments:Â Borrowing entails interest costs, which reduce net profits.
Tax Benefits:Â Interest expenses are often tax-deductible, reducing the overall cost of borrowing.
Preserved Liquidity: Borrowing preserves cash reserves, maintaining the company’s liquidity position.
How ROCE Demonstrates the Cost Benefits of Borrowing
According to the Law Society Financial Benchmarking Survey 2024, written by Hazlewoods Accountants results show a median ROCE of 30.0%
In the context of the returns made to the owners of a law firm, the calculation uses ‘super-profit’ as this takes account of notional salaries for partners, and notional interest on partners’ capital and so is representative of the reward to the partners for the risk they take in being owners of the business.
Evaluating the Cost of Debt: When a company considers borrowing, it must compare the cost of debt with its ROCE. If the company’s ROCE significantly exceeds the interest rate on the borrowed funds, it indicates that the firm can generate higher returns on the borrowed capital than the cost of the debt. For instance, if a company has a ROCE of 30% and can borrow at an interest rate of 6%, the 24% differential signifies a cost-effective use of debt.
Enhancing Shareholder Value: By leveraging debt at a lower cost than the company’s ROCE, businesses can enhance shareholder value. The increased returns generated from employing the borrowed capital, after accounting for interest payments, contribute to higher profitability and potentially increased dividends.
Tax Efficiency: Interest on debt is typically tax-deductible, providing a tax shield that reduces the company’s taxable income. This tax benefit effectively lowers the cost of borrowing, making it even more advantageous if the company’s ROCE is higher than the post-tax cost of debt.
Maintaining Optimal Capital Structure: A judicious mix of debt and equity can lead to an optimal capital structure, minimising the company’s weighted average cost of capital (WACC). Companies with a high ROCE are better positioned to benefit from debt financing, as the returns generated from the capital employed outweigh the borrowing costs, thus lowering the WACC.
Strategic Investment and Growth: Access to borrowed funds can enable strategic investments and growth opportunities that might not be feasible through internal funds alone. If these investments yield returns in line with or above the company’s current ROCE, the overall profitability and market position of the company are likely to improve.
Practical Example
A law firm, XYZ Solicitors, with a ROCE of 30%. XYZ Solicitors is contemplating tax funding that requires £200k. The firm can either use its cash reserves or borrow at an interest rate of 6%.
Using Own Cash: Deploying £200k in cash would generate a return based on the ROCE, i.e., £60,000 annually.
Borrowing Money: Borrowing £200k at 6% interest results in an annual interest cost of £12,000. The additional £200k, when employed at a 30% ROCE, would generate £60,000, leading to a net gain of £48,000 after interest.
In this scenario, borrowing clearly offers a substantial net benefit (£48,000) compared to using own cash.
Conclusion
ROCE is an invaluable tool in financial decision-making, helping law firms to assess the viability and cost-effectiveness of borrowing versus using own funds. When a law firm’s ROCE is higher than the cost of debt, borrowing can deliver significant cost benefits, preserve liquidity, and enhance shareholder value. By strategically leveraging debt, businesses can optimise their capital structure, achieve tax efficiencies, and drive sustainable growth.
Gemstone Legal is an independent finance broker that helps law firms to explore funding opportunities that can funding needs while protecting the cashflow of the business.
Get in touch at https://calendly.com/gemstonelegal/lawfirmfinancing
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