Translating an inspired idea into a robust business plan
002 The Free Cash Flow J-Curve
Free cash flow is a hugely important concept for business planners, managers and investors. Free cash flow is an essential metric when valuing companies based on discounted cash flow. This chart shows the free cash flow for a project of new business venture on a year by year basis (blue bars) and the cumulative free cash flow (orange line). The cumulative free cash flow is the cash flow for each year added year after year. The cumulative free cash flow line has the shape of the letter J and hence is referred to as the J-curve. Americans tend to call it the “hockey stick curve”.
Many businesses or projects will be initially cash flow negative because of set-up related capital expenditure, operational expenditure tends to exceed revenue, and working capital has to be funded. As revenue builds up and capex comes down the business will turn cash flow positive. In the example this occurs in year 4. In each of first 3 years the annual cash flow is negative. By the end of year 3 there have been 3 years worth of negative cash flows before turning positive in year 4. Year 3 is the year of “peak funding”. Peak funding is the amount of cash that has to be invested in the business because it starts to turn cash flow positive.
Ideally a project is fully funded from the start. This does not mean that the total funding requirement is raised at the outset, but commitment from equity investors or lenders must be in place or there is a risk that the project fails because funding cannot be secured at a later stage.
The next important point occurs in year 5. At the end of year 5 the initial negative cash flows are recouped by positive cash flows in years 3 and 4. This means “pay back” occurs in year 5. Many businesses use pay back and Net Present Value to decide whether a project should go ahead. In principle projects with a shorter payback time are less risky and are more cash generative. The latter point is important in cases where capital is scarce.
In the example, the project is big capital intensive business and cash flow is measured in years. However, for many smaller projects or businesses you can produce the same chart in monthly or quarterly intervals, as appropriate. Greater granularity has the advantage of identifying the true peak funding in cases where a project turns cash flow positive during a year. For example the peak funding may occur in June, and by the end of the year already some positive cash flows have occurred. Hence looking at the picture on an annual basis would understate the peak funding requirement. This is an illustration that good business planning requires a certain degree of granularity.