Dollinger index

274 ENTREPRENEURSHIP

For example, a new venture with a positive cash flow conversion cycle (it spends

before it receives) could borrow 70 percent of the money needed to finance accounts

receivable with the receivables themselves as collateral. Up to 60 percent debt financing

is possible for inventory with the inventory as collateral. Note that the more stable, long-

term, and tangible resources have higher debt ceilings; the short-term, high-turnover

assets have lower ceilings.

Smaller banks have traditionally turned away from asset-based financing because they

lacked the ability to evaluate and dispose of collateral. However, these banks are increas-

ingly moving toward developing special expertise in asset-based financing. In 1989, it

was estimated that small businesses would borrow over $100 billion with asset-based

financing.^25

Cash flow financing refers to unsecured financing based on the underlying opera-

tions of the business and its ability to generate enough cash to cover the debt. Short-

term (under one year) unsecured financing is usually used as temporary working capi-

tal. A line of credit is an intermediate level of unsecured financing. Long-term unsecured

financing takes the form of a note, bond, or debenture. Because the debt is unsecured,

banks may take other precautions to protect their asset (the loan). These protections or

covenantsare agreements between lender and borrower concerning the manner in

which the funds are disbursed, employed, managed, and accounted. For example, an

unsecured loan covenant might require the borrower to maintain a certain minimum

balance in an account at the lending institution. In this way, the bank can restrict a por-

tion of its funds from general use, raise the cost of the loan to the borrower, and poten-

tially attach the balance in case of default. Further details on this type of financing and

its limits are discussed in the next chapter.

Before we leave the subject of cash flow and debt financing, let’s take a look at the

unfortunate story of Ruminator Books, which faced severe financial problems and went

looking for a solution. Did they find it? The answer is in Street Story 7.4.

Type

Accounts receivable

Inventory

Equipment

Conditional sales contract

Plant improvement loan

Leasehold improvement

Real estate

First mortgage on building

Borrowing Limits

For short-term receivables: 70%–80%;

for longer-term receivables: 60%–80%a

Depending on risk of obsolescence: 40%–60%

If equipment is of general use: 70%–80%;

if highly specialized: 40%–60%

As a percentage of purchase price: 60%–70%

Lower of cost or market appraisal: 60%–80%

Depending on general reusability: 70%–80%

Depending on appraisal value: 80%–90%

Depending on appraisal value: 80%–90%

a This is from a factor, a business that specializes in collecting accounts receivable and overdue

debts for firms and lending them money against the total invoice amounts.

TABLE 7.2 Asset-Based Financing and Borrowing Limits